Loyola University Chicago School of Law, JD 2019
On December 20, 2017, Congress passed the Tax Cuts and Jobs Act (“TCJA”) designed to decrease the taxable rate for corporations and individuals, and significantly limited allowable deductions. Since this change to the Tax Code was one of the largest since the Reagan era, the Internal Revenue Service will need to publish many regulations and advisories in the coming months to better clarify provisions of the TCJA. This multi-part series will explore prominent IRS regulations and advisories as they relate to the TCJA, and what these regulations and advisories mean for both individual and corporate taxpayers.
Following the passage of the TCJA, there has been confusion among taxpayers regarding some long-standing deductions which the TCJA seemed to eliminate. The confusion stems from both a decrease in the home acquisition debt deduction, from $1 million to $750,000, and complete elimination of the home equity debt deduction. However, the IRS released a notice on February 21, 2018 clarifying which home equity loans are still deductible under the TCJA. In the February 21st notice, the IRS advised taxpayers that in many cases, taxpayers can continue to deduct interest paid on home equity loans.
However, as a result of this advisory, taxpayers need to consider how various loan decisions can affect their ability to deduct home interest on their personal tax statements. Following this IRS advisory, homeowners may still be confused as to which interests are deductible, and what circumstances will still allow them a deduction like pre-TCJA allowable deductions.
Understanding Home Equity Loans and Home Equity Line of Credit
Home-equity loans are often referred to as “second mortgages,” but the two function primarily the same. Home-equity loans allow homeowners to borrow money through securing the loan in the equity of their homes and using the house as collateral. The equity of the home is the difference between the fair market value of the home, and the remaining balance (debt) on the mortgage. A home-equity line of credit (“HELOC”) is a type of home-equity loan and is a line of credit secured by a homeowner’s home. Unlike a general home-equity loan, HELOC gives the borrower a revolving credit line to use for large expenses or to consolidate higher-interest rate debt on other loans such as credit cards.
Taxpayers and homeowners may decide to take on home-equity loans for any reason. Unlike home acquisition debt, which is only allowable for the purchase of a home, home-equity loans can be used for a variety of reasons. Frequently, people decide to use home-equity loans for general home improvements, funding children’s college education, or paying off credit card debt.
Home Equity Interest and TCJA Deductibility
Prior to the TCJA, homeowners were able to deduct from their taxes the interest earned from these home-equity loans, up to $100,000. If the earned interest was lower than $100,000, the taxpayers were able to deduct the earned interest or $100,000, whichever was lesser. The confusion regarding home equity interest deductibility is a result of the congressional conference report explaining the provisions of the TCJA. In the congressional conference report, it stated that the deduction for interest on home equity debt is suspended. It was valid that taxpayers believed that this was no longer an allowable deduction.
However, under the IRS February 21st advisory, most home equity lines of credit and second mortgages remain deductible. In this advisory, the IRS clarified that through 2026, the “deduction for the interest paid on home equity loans and lines of credit [is suspended] unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.” This deduction is allowed, regardless of how the loan is labeled. Therefore, interest on a home equity loan is deductible, assuming that is used to build an addition or substantially improve an existing home (i.e. the home that secures the loan) but is not deductible if the same loan is also used to pay personal living expenses.
Understanding Ceiling of Interest from Home Equity Interests and Qualified Residence Loan Balances
Although the primary focus of the IRS Advisory IR-2018-32 is a clarification of the home-equity interest deduction, the advisory also reminds taxpayers that the TCJA imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction and how this affects the amount of deductibility for home-equity interest.
Starting in 2018 (represented on the 2019 tax filing), taxpayers can only deduct interest on $750,000 of qualified residence loans ($375,000 for married filing separately). These are down from the prior limit of $1 million (or $500,000 for married filing separately). If the qualified residence loan interest does not exceed $750,000, any remaining home equity interest may be applied against that total. The IRS provides an example demonstrating this advisory:
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 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 1, IR-2018-32
How does this affect Individual Taxpayers?
Taxpayers should be vigilant to understand and document how they are using home-equity funds to claim the deduction. Under this advisory, the IRS has clarified that a home equity loan that is used to substantially improve the home which secures the loan, has an allowable deduction for the incurred interest from that home equity loan. It is important that taxpayers understand that any other uses of the home equity loans will not be an allowable deduction through 2026.
It is likely that because of this advisory, fewer homeowners will take out home equity loans. Previously, if people had the funds to secure a home equity loan and knew that they would be able to pay back the loan rather quickly, they would secure a home equity loan for receiving a tax deduction. However, taxpayers looking to finance credit card debt, or student tuition costs, will likely choose different financing options that are less risky (e.g. the homeowner does not need to use their home as collateral). Because of the TCJA, it is likely that the only taxpayers who will use home-equity funds will be those looking to make home improvements.