One of the more painful revisions of the Internal Revenue Code arising from the Tax Cuts and Jobs Act (TCJA), enacted on December 22, 2017, was the repeal of the long-standing itemized deduction for interest paid on home equity indebtedness of $100,000 or less. To qualify for the tax deduction, the indebtedness had to be secured by a legally registered lien against a personal residence property.
Most often, home equity indebtedness was provided by lenders in the form of a home equity line of credit, again, secured by a personal residence. Prior-law tax rules did not limit the deduction based on how the taxpayer spent the borrowed proceeds. As such, many taxpayers used the borrowed proceeds to fund major purchases, such as automobiles and vacations.
Aware of the use of these lines of credit for personal expenditures, and looking for potential revenue raisers, Congress saw fit to repeal the provision in its entirety in the TCJA. As such, after the enactment of the tax bill, interest on home equity loans was no longer deductible. This change is effective for tax years beginning after December 31, 2017 and ending before January 1, 2026.
The general mortgage interest deduction for amounts borrowed to finance the acquisition or improvement of a personal residence continues to be deductible so long as the debt constitutes this “home acquisition indebtedness.”
Because interest on home acquisition indebtedness continues to be deductible, taxpayers were confounded as to why amounts drawn against a home equity line of credit or a straight home equity loan were not deductible if the proceeds were spent for the acquisition of a home or the improvement of a home. Most commentators saw this anomaly as simply an oversight matter that would be clarified at some later point in time.
That time came this week as the Internal Revenue Service issued an advance release, IR 2018-32, clarifying the issue. The release specifies that home equity loan interest is still deductible so long as the proceeds of the loan/line of credit are used to buy, build or substantially improve the home securing the loan.
As an example, the notice sets out the example that interest on a home equity loan used to build an addition to an existing home would be deductible. On the other hand, interest on a loan used to pay credit card debts would not be deductible. In addition, to be deductible, the loan must be secured by the taxpayer’s main home or second home, cannot exceed the cost of the home, and must meet other requirements. The news release contains further examples of how the new rules work.
Also, keep in mind that under the new law, there is a lower dollar limit on mortgages that qualify for the home mortgage interest deduction. Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The limit applies to the combined amount used to buy, build or substantially improve the taxpayer’s main home and second home.