IRS Issues Clarification on Deductibility of Home Equity Loans

The IRS has just advised taxpayers (in IR-2018-32) that in many cases they can continue to deduct interest paid on a home equity loan, home equity line of credit (HELOC) or second mortgage regardless of how the loan is labelled. Specifically, the IRS notes that the Tax Cuts and Jobs Act of 2017 (TCJA) suspends the deduction of interest paid on home equity loans and lines of credit for taxable years beginning after December 31, 2017 unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan. The suspension ends for taxable years beginning after December 31, 2025.

Subject to certain transition rules for binding written contracts and refinancings of existing debt, under the TCJA, for taxable years beginning after December 31, 2017, taxpayers may only deduct interest on $750,000 of qualified residence loans, down from $1,000,000. The limit is $375,000 for a married taxpayer filing separately. A qualified residence means the taxpayer’s principal residence and one other residence of the taxpayer selected to be a qualified residence. A qualified residence can be a house, condominium, cooperative, mobile home, house trailer or boat. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main and second home. 

The IRS release contains three illustrative examples, provided below.

Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible.

Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home.  The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. However, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.

Example 3: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible. A percentage of the total interest paid is deductible (see Publication 936).  

So while it may have seemed that all home equity loans are now nondeductible after the enactment of the TCJA, the IRS has alerted us that it isn’t necessarily so.