Home equity can be a beneficial financial tool for homeowners, either in the form of a home equity loan or line of credit. Not only does home equity offer an affordable way to finance major purchases and consolidate debt, but it also comes with a helpful tax break for those who qualify.
However, at the end of 2017, the Tax Cuts and Jobs Act was swiftly passed, creating some confusion surrounding individual and business tax circumstances moving forward. Many outlets reported that one of the biggest shifts for individual taxpayers would be the loss of deductibility of home equity interest. Now that the IRS has had time to interpret the tax changes, homeowners have more clarity on what they can – and cannot – deduct when it comes to home equity. Here’s what you need to know.
IRS Guidelines for Home Equity Deductions
As part of the Tax Cuts and Jobs Act of 2017, mortgage interest deductions were modified across the board. Previously, an interest deduction was available for up to $1,000,000 of mortgage loans, and $100,000 of home equity debt in any form. Now, interest accrued on up to $750,000 of qualified residence loans can be deducted.
The definition of a qualified residence loan comes into play heavily in the new tax law, as it requires the debt to be secured by the primary or secondary home of the taxpayer, along with meeting other qualification requirements in order to be deductible.
For home equity borrowers under the new law, that means a few changes. Technically, the tax reform suspends deductions for interest paid on home equity lines of credit and loans, from 2018 to 2026. But there is a significant exception that took some time to uncover. When the funds of a loan are used for the purpose of buying, building, or improving the property that secures the equity loan, it becomes a qualified personal residence and interest is therefore deductible.
To put that in simpler terms, borrowing money in the form of a home equity loan or line of credit against your primary home to renovate, remodel, or expand, your loan or line of credit interest is deductible.
When a home equity loan or line of credit falls under these guidelines, there is no cap. So, if a $150,000 home equity loan or line of credit is used to improve the home, potentially all interest paid is deductible. Several examples are available on the IRS website detailing its interpretation of the law.
What Isn’t Covered
Previously, tapping into a home equity loan or line of credit was a potentially tax-benefited way to pay for significant expenses not tied directly to the home itself. For instance, homeowners could use their equity to pay for a family vacation, cover college expenses for a child or grandchild, or consolidate debt on credit cards or high-interest personal loans. Although home equity loans and lines of credit may still be used for these purposes in an affordable way, the interest paid is not deductible in these circumstances.
Additionally, home equity loans and lines of credit taken out prior to the enactment of the new tax law are not grandfathered in. This means that homeowners who used home equity in the past to pay for unqualified expenses and deducted the interest paid will no longer have the opportunity to do so moving forward.
The Bottom Line
Many homeowners who use the equity in their primary or secondary homes to remodel, renovate, or otherwise improve the property are still able to deduct the interest paid on a home equity loan or line of credit, up to certain limits. It is when home equity is used for other costs unrelated to the home where homeowners miss out on a powerful tax benefit.
The tax law changes are still fresh, which means more interpretation may be down the line for homeowners and borrowing against their equity. However, for now, many still qualify to deduct paid interest on home equity loans and lines of credit.
