Tax Reform: IRS clarifies interest on HELOC often deductible

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There seems to be confusion regarding how the new Tax Laws affect the interest deductibility of home equity loans and HELOCs. A lot of folks think the new laws do not allow deductibility of interest on their HELOC. While it is true the interest deduction for "home equity debt" is eliminated, many HELOCs will still qualify for an interest deduction. "Home equity debt" is not the same as Home Equity Loans/HELOCs. You must look at whether your HELOC meets the definition of "acquisition indebtedness".

As I have been communicating to my clients, in many instances, interest on HELOCs are still deductible, despite what others might tell you. The IRS has provided their position as well in IR 2018-32. See below for clarification from the IRS. 

In addition to the below, under interest tracing rules, HELOC interest could also be deductible against your business/rental income. The below is intended for taxpayers who are not using their HELOC to fund a business/rental purchase.

Be sure to consult with your CPA/Tax Professional for specific advice based on your individual facts and circumstances.

IR 2018-32

In an Information Release, IRS has announced that in many cases, taxpayers can continue to deduct interest paid on home equity loans under the recently enacted Tax Cuts and Jobs Act (PL 115-97, 12/22/2017).

Background. Taxpayers may deduct interest on mortgage debt that is “acquisition debt.” Acquisition debt means debt that is: (1) secured by the taxpayer's principal home and/or a second home, and (2) incurred in acquiring, constructing, or substantially improving the home. This rule hasn't been changed by the Tax Cuts and Jobs Act.

Under pre-Tax Cuts and Jobs Act law, the maximum amount that was treated as acquisition debt for the purpose of deducting interest was $1 million ($500,000 for marrieds filing separately). This meant that a taxpayer could deduct interest on no more than $1 million of acquisition debt. Taxpayers could also deduct interest on “home equity debt.” “Home equity debt,” as specially defined for purposes of the mortgage interest deduction, meant debt that: (1) was secured by the taxpayer's home, and (2) wasn't “acquisition indebtedness” (that is, wasn't incurred to acquire, construct, or substantially improve the home).

Thus, the rule had allowed deduction of interest on home equity debt and enabled taxpayers to deduct interest on debt that wasn't incurred to acquire, construct, or substantially improve a home—i.e., on debt that could be used for any purpose. As with acquisition debt, the pre-Tax Cuts and Jobs Act rules limited the maximum amount of “home equity debt” on which interest could be deducted; here, the limit was the lesser of $100,000 ($50,000 for a married taxpayer filing separately), or the taxpayer's equity in the home

Under the Tax Cuts and Jobs Act, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the limit on acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately). The $1 million, pre-Tax Cuts and Jobs Act limit applies to acquisition debt incurred before Dec. 15, 2017, and to debt arising from refinancing pre-Dec. 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. (Code Sec. 163(h)(3)(F))

Under the Tax Cuts and Jobs Act, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, there is no longer a deduction for interest on “home equity debt.” The elimination of the deduction for interest on home equity debt applies regardless of when the home equity debt was incurred. (Code Sec. 163(h)(3)(F))

New guidance. In IR 2018-32, IRS said that despite the newly-enacted restrictions on home mortgages under the Tax Cuts and Jobs Act, taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC), or second mortgage, regardless of how the loan is labelled.

IRS clarified that the Tax Cuts and Jobs Act suspends the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer's home that secures the loan.

For example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses—such as credit card debts—is not. As under pre-Tax Cuts and Jobs Act law, for the interest to be deductible, the loan must be secured by the taxpayer's main home or second home (known as a qualified residence), not exceed the cost of the home and meet other requirements.

For anyone considering taking out a mortgage, the Tax Cuts and Jobs Act imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. The lower limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer's main home and second home.

IR 2018-32, provides the following examples:

Illustration 1: In January 2018, John takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, he 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 John 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.

Illustration 2: In January 2018, Mary takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, she 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 Mary 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.

Illustration 3: In January 2018, Bob takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, he 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. Only a percentage of the total interest paid is deductible.

Nice to have an official confirmation, but most of tax pros, including you and I, already interpreted it this exact way

This was meant more for the general public than tax professionals. Although a couple of my new clients have been misinformed by their prior Accountants...

Originally posted by @Lance Lvovsky :

This was meant more for the general public than tax professionals. Although a couple of my new clients have been misinformed by their prior Accountants...

Only a couple? :) 

What if I take out a HELOC on my personal residence to finance the acquisition of a commercial real estate investment? In that scenario, would the interest on the HELOC be deductible as a business expense?

Great info, thank you! What about HELOCs used to generate interest income i.e. HELOCs funds used for hard money loans? Can the interest on the HELOC be deducted against the interest income of the loan?

Originally posted by @Wells Mangrum :

What if I take out a HELOC on my personal residence to finance the acquisition of a commercial real estate investment? In that scenario, would the interest on the HELOC be deductible as a business expense?

Yes, it will be deductible on the business schedule: Sch E if reported on your personal return or Form 8825 if reported under a partnership or an S-corporation.

Originally posted by @James K. :

Great info, thank you! What about HELOCs used to generate interest income i.e. HELOCs funds used for hard money loans? Can the interest on the HELOC be deducted against the interest income of the loan?

This is tricky. Deductible - yes, in principle, as an "investment interest."  However, with the new doubled standard deduction, you may not have enough itemized deductions to benefit from it. If so - you will need to restructure your lending business, possibly as an S-corp.

A HELOC was never deductible on Schedule A or E for "any purpose". It was always only for home improvement or additions. You could never take out a HELOC, go buy a BMW, and deduct the interest on your tax return.
Originally posted by @Jamie Engledow :
A HELOC was never deductible on Schedule A or E for "any purpose". It was always only for home improvement or additions. You could never take out a HELOC, go buy a BMW, and deduct the interest on your tax return.

That is not correct. Before the tax reform, you could deduct interest on $100k of HELOC used for any purpose, including a BMW. Not anymore.

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