Are you planning to take out a home equity loan to pay for home improvements? Unfortunately, the Tax Cuts and Jobs Act (TCJA) cracks down on mortgage interest deductions for home equity loans, among other changes. However, if you play your cards right, you may have an ace in the hole.
How it works: Due to the way the IRS interprets the law, you can still deduct mortgage interest deductions on home equity loans when the proceeds are used for home improvements (IR-2018-32, 2/21/18). It all has to do with the tax law distinction between loans treated as “acquisition debt” and those that are characterized as “home equity debt.”
The basic rules are as follows: Generally, you can deduct mortgage interest you pay during the year if you itemize deductions. To qualify, you must be legally obligated to pay the mortgage secured by a qualified residence. For this purpose, a qualified residence may be your principal residence and one other home, such as a vacation home.
The deduction depends on whether the debt is an acquisition debt or a home equity debt.
- Acquisition debt: This is a debt incurred to “buy, build or substantially improve” a qualified home. Prior to the TCJA, mortgage interest paid on up to $1 million of acquisition debt was fully deductible.
- Home equity debt: Any other qualified debt, such as a home equity loan or line of credit, is treated as home equity debt. Previously, mortgage interest paid on up to $100,000 of home equity debt was deductible, regardless of how the proceeds were used.
In other words, you could deduct the interest even if you used the money to take a vacation or buy a new car.
But the TCJA changed the lay of the land. For acquisition debt, the threshold is reduced from $1 million to $750,000 for 2018 through 2025. This new limit generally applies to debts incurred after December 15, 2017. (Deductions for existing acquisition debts are grandfathered even if they are subsequently refinanced up to the remaining amount of debt.)
Even worse, the deduction for interest on home equity debt is completely eliminated for interest paid in 2018 through 2025. This is a problem for many borrowers.
Key point: If you take out a new home equity loan or line of credit and use the proceeds for home improvements like a finished basement or deck, the debt is treated as acquisition debt instead of home equity debt. It qualifies as a debt incurred to “substantially improve” a qualified residence. Therefore, the interest is deductible as long as the total amount of the debt doesn’t exceed the original purchase price and you stay below the new $750,000 threshold for acquisition debt.
In fact, just a small money management change can salvage a deduction. For instance, if you were planning to use bank account funds for a home improvement and take out a home equity loan to help pay for some of your child’s college expenses, you might switch the use of the funds. As a result, you can convert a nondeductible interest expense into deductible interest.
Note: Special rules apply to home equity loans in certain states like Texas. Consult with your JMF tax advisor for your situation.