Tax Loophole Found for Home Equity Loan Interest

Tax Loophole Found for Home Equity Loan Interest

The Tax Cuts and Jobs Act of 2017 introduced a slew of new tax breaks while doing away with others, one of which affects tax benefits for home equity loan interest. Much of that deduction was effectively eliminated, at least through the end of 2025. The Internal Revenue Service (IRS), however, has allowed for a loophole in the tax law that would permit some homeowners to continue benefiting from the home equity loan interest deduction.

Several other tax changes directly affected taxpayers who own a home or plan to purchase one, including a reduction of the limit on deductible mortgage debt to $750,000 for loans taken out after Dec. 14, 2017. The previous limit was $1 million. In addition, going forward there’s a cap of $10,000 on itemized deductions for state and local taxes (SALT), including property taxes.

Key Takeaways

  • Despite the provisions of the Tax Cut and Jobs Act, the IRS in a 2018 advisory stated that home equity loan interest is still deductible, as is interest on HELOCs and second mortgages.
  • To qualify for the deduction, the loan money must be for an IRS-approved use: namely, to “buy, build, or substantially improve the taxpayer’s home.”
  • The money cannot be used to pay off personal debts or other expenses.
  • The deduction is not unlimited; the total amount of mortgage-related debt interest that can be deducted beginning in 2018 is $750,000.

New Rules for Deducting Home Equity Loan Interest

In February 2018 the IRS issued an advisory for taxpayers regarding the status of the home equity loan interest deduction. The advisory specified that interest on home equity loans, home equity lines of credit (HELOCs), and second mortgages is still deductible, regardless of how the loan is labeled, as long as the loan is for an IRS-approved use. Specifically, home equity loans, HELOCs, and second mortgages must be used to “buy, build, or substantially improve the taxpayer’s home that secures the loan” for interest to be deductible. 

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While the IRS didn’t include a list of expenses that would be covered under the law’s provisions, the advisory did include some examples of allowable home-improvement expenses, such as building an addition to expand your home. Other purposes that qualify for the deduction if you’re using a home equity loan or HELOC are:

  • Putting a new roof on the property
  • Replacing your HVAC system
  • Completing an extensive kitchen or bathroom remodeling project
  • Resurfacing your driveway

Impact of the New Home Equity Loan Rules

The preservation of the deduction for eligible taxpayers is good news for homeowners. An Oct. 2017 TransUnion report estimated that more than two-thirds of homeowners could be eligible for a HELOC, and HELOC originations are expected to reach up to 11 million by 2022. The report also estimated that the number of consumers who open a HELOC by 2022 will be more than double the rate of those who did so between 2012 and 2016. Keeping the home equity loan deduction—even in limited form—may also have positive implications in encouraging homeownership.

Other provisions of the tax bill could have the opposite effect. In addition to the severe cut in the state and local taxes deduction, the standard deduction has almost doubled, to $12,000 for single filers and $24,000 for married couples filing a joint return. According to a 2017 report from the National Association of Realtors, the higher standard deduction was expected to shrink the number of taxpayers who’d find it advantageous to claim mortgage interest and property tax deductions by itemizing. And, indeed, according to a report in the New York Times based on IRS statistics, 21% of taxpayers claimed the mortgage interest deduction for tax year 2017, but only 8% did so for tax year 2018. This means there was no tax differential between renting and owning for more than 90% of taxpayers.

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Still, retaining the home equity loan deduction may be viewed as an added incentive to buy instead of rent.

8%

The amount of taxpayers who took the mortgage interest deduction in tax year 2018.

Best Practices for Claiming the Home Equity Interest Deduction

If you own a home and are planning to claim the home equity loan interest deduction, there are a few things to remember. First, the money must be used for home improvements or renovations. You can’t take the deduction if you’re using home equity to pay for personal expenses or consolidate credit card debts. The same goes if you’re taking out a loan and letting the money sit in the bank as your just-in-case fund for emergencies.

What’s more, the renovations have to be made on the property on which you are taking out the home equity loan. You can’t, for example, take out a loan on your primary residence and use the money to renovate your cottage at the lake.

Next, keep proper records of your expenses. The odds of being audited by the IRS are generally low, but you don’t want to take any chances. If you’re planning to use a home equity loan or HELOC to pay for home repairs or upgrades, be sure to keep receipts for everything you spend and bank statements showing where the money went.

Finally, remember that the deduction is not unlimited. The total amount of mortgage-related debt interest that can be deducted is $750,000. If you have a large amount of equity and a large first mortgage loan, you may not be able to deduct all the combined interest paid. As interest on older mortgages is grandfathered to $1 million loans, check carefully with your accountant about what you can deduct if you have both an older mortgage and a home equity loan that qualifies for deductions.

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The Bottom Line

A home equity loan or HELOC can be a convenient source of funding when you want to spruce up your home. Snagging a tax deduction for the interest you pay is an added perk. As with any other loan, however, take the time to compare interest rates and loan terms from different lenders to find the best deal possible.

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