Under prior tax law, taxpayers who itemized deductions could deduct “qualified residence interest” on up to $1 million of debt secured by a qualified residence and used to acquire, build or improve that residence (referred to as “acquisition debt”), plus interest on home equity debt up to $100,000. (The limits were half those amounts for married taxpayers filing separately.) The home equity debt couldn’t exceed the fair market value (FMV) of the home reduced by the debt used to acquire the home.
But the $100,000 limit didn’t apply to the extent the home equity debt qualified as acquisition debt. For example, if the home equity debt was used to improve the home securing that debt, the $100,000 limit didn’t apply.
For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence, which can be a house, condominium, cooperative, mobile home, house trailer or boat (if it has kitchen and bathroom facilities). The principal residence is where the taxpayer resides most of the time; the second residence is any other residence the taxpayer owns and treats as a second home.
Taxpayers aren’t required to use the second home during the year to claim the deduction. If the second home is rented to others, though, the taxpayer also must use it as a home during the year for the greater of 14 days or 10% of the number of days it’s rented.
If a taxpayer had a principal residence and a second residence, the $1 million debt limit applied on an aggregate basis; it wasn’t $1 million per home. Home equity debt that qualified as acquisition debt was also generally subject to the aggregate $1 million limit.
Interest on home equity debt up to the $100,000 limit was deductible regardless of how the proceeds were used. A taxpayer could, for example, use the proceeds to pay for medical bills, tuition, vacations, vehicles and other personal expenses and still claim the itemized interest deduction.
In addition, courts had ruled that the $100,000 limit could also apply to home equity debt that qualified as acquisition debt, effectively meaning a taxpayer could deduct interest on acquisition debt up to $1.1 million in certain circumstances.
The TCJA rules
The TCJA reduces the limit on the amount of the mortgage interest deduction through 2025. Beginning in 2018, for mortgage debt incurred after December 15, 2017, a taxpayer generally can deduct interest only on mortgage debt of up to $750,000, or $375,000 for separate filers. (For debt incurred on or before that date, the debt limit remains at $1 million or $500,000, respectively.)
The congressional conference report on the law stated that it also suspends the deduction for interest on home equity debt. And the actual bill includes the section caption “DISALLOWANCE OF HOME EQUITY INDEBTEDNESS INTEREST.” As a result, many people believed the TCJA eliminated the home equity debt interest deduction.
On February 21, 2018, the IRS issued a release (IR 2018-32) explaining that the law suspends the deduction only for interest on home equity loans and lines of credit that aren’t used to buy, build or substantially improve the taxpayer’s home that secures the debt. In other words, the interest isn’t deductible if the home equity debt is used for certain personal expenses, but it is still deductible if it’s used in a way that allows it to qualify as acquisition debt, such as if the proceeds go toward a new roof on the home that secures the debt.
The IRS further stated that the $750,000 limit applies to the combined amount of mortgage and home equity acquisition debt.
Some examples from the IRS help show how the TCJA rules work:
Example 1: A taxpayer took out a $500,000 mortgage to buy a principal residence with an FMV of $800,000 in January 2018. The loan is secured by the residence. In February, he took out a $250,000 home equity loan to pay for an addition to the home. Both loans are secured by the principal residence, and the total doesn’t exceed the value of the home.
The taxpayer can deduct all of the interest on both loans because the total loan amount doesn’t exceed $750,000. If he used the home equity loan proceeds to pay off student loans and credit card bills, though, the interest on that loan wouldn’t be deductible.
Example 2: The taxpayer from the previous example took out the same mortgage in January. In February, he also took out a $250,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages doesn’t exceed $750,000, he can deduct all of the interest paid on both mortgages. But, if he took out a $250,000 home equity loan on the principal home to buy the second home, the interest on the home equity loan wouldn’t be deductible.
Example 3: In January 2018, a taxpayer took out a $500,000 mortgage to buy a principal home, secured by the home. In February, she took out a $500,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages exceeds $750,000, she can deduct only a portion of the total interest she pays on them.
The IRS announcement highlights the fact that the nuances of the TCJA will take some time to shake out completely.
Have questions? Contact William Rogers.