The Service recently responded to widespread confusion surrounding changes made through the Tax Cuts and Jobs Act by announcing that taxpayers can often still deduct interest on a home equity loan, home equity line of credit or second mortgage, without regard to the label placed on the loan.
Tax reform imposed a lower limit of $750,000 ($375,000 MFS) on mortgages qualifying for the interest deduction. The limit is applicable to the combined amount of all loans used to buy, build or substantially improve the taxpayer’s main home and second home. Under the new law, 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 prior law, 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. The least understood aspect of these changes, and the topic generating a lot of discussion among practitioners, is the fact that the loan must be used to buy, build or substantially improve the home that secures the loan. IRS put forth the following example to illustrate the point.
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.
So, what are the takeaways? Well, home equity debt and lines of credit may no longer be used for simply any purpose and still be deductible. They must be used to buy, build, or substantially improve the home that secures the loan. Yes, you read that correctly. Your neighbor can no longer utilize the appreciation in his or her home value and its resulting equity to finance the motorcycle, boat or vacation to Portofino. But there is a larger point here. Many astute taxpayers would intentionally take out a second mortgage on their primary residence and use the funds to purchase a vacation home. This was a common strategy because the mortgagee bank would typically give a markedly better rate on a second loan on the primary residence as opposed to an acquisition loan on the vacation property. The bank reasoned that if unforeseen calamity struck, the borrower would beg, borrow and steal to keep up the payments to stay in the primary residence but could very well let the vacation home go to foreclosure. Hence, the bank would have an incentive to keep the leverage all on the primary residence and would gladly give a better rate to the note on that primary residence. Well, such savings for the borrower are gone – possibly one more unintended consequence of tax reform.
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Nick Spoltore is VP of Tax & Advisory Content for Surgent CPE. Mr. Spoltore is a graduate of the University of Notre Dame and of Delaware Law School. Before joining Surgent, he practiced tax and business law at the firm of Heaney, Kilcoyne in Pennsylvania and also in Delaware.