Starting in 2018, the Tax Cuts and Jobs Act of 2017 significantly changed the rules surrounding mortgage interest deductions on second mortgages, including home equity loans and home equity lines of credit (HELOCs). Homeowners with outstanding home equity debt will no longer be able to deduct their interest paid unless the loan proceeds were used for qualified home purchase or improvement expenses. Here's what you'll need to know about your home equity loan under the new tax law.
Are Home Equity Loans and HELOCs Tax-Deductible in 2018?
Yes, the interest paid on home equity loans and home equity lines of credit is still tax deductible, even in 2018 and beyond. However, it will be subject to stricter requirements. The Tax Cuts and Jobs Act of 2017 eliminates the deduction for interest paid on home equity loans and lines of credit for tax years 2018-2026 unless you those funds are used to purchase, renovate or substantially improve your primary or second home.
Home Equity Loan and HELOC Deductions - By the Numbers
- From 2018 through 2026, the interest deduction on home equity debt (including home equity loans and HELOCs) has been eliminated for all expenses aside from costs incurred to purchase, substantially improve or renovate underlying property.
- Any eligible deduction will be limited to the original purchase price of the underlying home. Home equity debt on significantly appreciated properties will not be tax-deductible beyond the original purchase price of the home.
Starting in 2018, American taxpayers with home equity loans and HELOCs will no longer be able to deduct the interest paid on loans used for personal expenses, such as debt consolidation, education expenses or car purchases. In prior years, it was possible to deduct the interest paid on home equity debt of up to $100,000, regardless of how the money was used.
Depending on when your primary or second mortgage was obtained, you’ll be subject to the following tax rules for all mortgage debt outstanding, across both primary homes and second homes owned, not just home equity financing.
New Deduction Caps on All Mortgage and Home Equity Debt
- Mortgage debt, including home equity loans and home equity lines of credit, obtained for home acquisition or improvement costs after Dec. 15, 2017 will be subject to the new $750,000 balance cap on all mortgage debt outstanding.
- Mortgage debt, including home equity loans and HELOCs, obtained for home acquisition or improvement costs prior to December 15, 2017 are grandfathered in at the $1 million balance cap.
- Deductible interest on eligible home equity proceeds no longer subject to $100,000 balance cap.
Which Home Equity Expenses are Deductible?
Ultimately, the IRS will decide which expenses are eligible for the deduction and which aren’t. According to Vinay Navani, CPA and shareholder at Wilkin & Guttenplan, a New Jersey-based public accounting firm, “The interest deduction is allowed when you make home improvements that increase the value of your home, prolong your home’s useful life, or adapt your home to a new use.”
Eligible or qualified uses for home equity proceeds include:
- Purchase of a primary residence or second home
- Construction of a primary residence or second home
- Renovation and rehabilitation costs for capital improvements to a primary residence or second home
Using the definition above as a rule of thumb, this means that many structural changes to homes, such as adding a new wing or replacing appliances in an outdated fixer-upper may be qualified expenses. However, cursory items that can be easily removed and serve only to decorate the property— for example, home furnishings, art, and collectibles are not eligible expenses and will not qualify for the deduction.
Additionally, home equity loans used to fund your lifestyle, like weddings, car purchases or vacations will receive the same tax treatment as personal loans and will not be eligible for the deduction. This also applies to home equity debt used to fund education and business expenses. Student loan interest is generally tax-deductible on its own, and may be a better way to pay for expenses related to college.
Non-deductible expenses for home equity proceeds include, but are not limited to the following:
- Cursory, non-permanent improvements to your property, such as home furnishings, artwork and decor
- Debt consolidation or refinances, including credit cards or personal loans
- Lifestyle expenses, such as weddings, vacations and travel
- Education costs, such as tuition, textbooks and student housing
- Business financing and startup costs, including inventory and payroll
- Big ticket purchases, like automobiles, boats or engagement rings
IRS guidance on home equity interest deduction has been limited, suggesting that many cases will have to be evaluated on an individual basis. The IRS provided the following examples in its press release, clarifying the matter (IR-2018-32):
Example 1: Primary Mortgage + Deductible Second Mortgage
In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible.
Example 2: Primary Mortgage + Non-deductible Vacation Home Purchase Using Home Equity Loan
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 another $250,000 mortgage 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.
Example 3: Primary Mortgage + Additional Mortgage on Vacation Home that Exceeds Deduction Cap
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 $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible. A percentage of the total interest paid is deductible.
What if My Home Equity Loan or HELOC Started Before 2018?
The new tax rules apply to both existing home equity loans and HELOCs in addition to new ones going forward. This means that if you used your second mortgage for an eligible home purchase or capital improvement to your property prior to Dec. 15, 2017 then you should still be able to claim a deduction for the interest. However if the proceeds of these loans were used for non-qualifying expenses, the interest on the mortgage will no longer be deductible for the 2018 tax year and beyond.
It’s also possible that only a portion of the interest is eligible for the deduction, especially if some of the loan proceeds were used for personal expenses in tandem with home improvements. For example, if you took out a home equity loan for $80,000 and spent $50,000 on a room addition, but the other $30,000 consolidating your credit card debt, then only the interest paid on the $50,000 room addition would be eligible for a tax deduction.
What Should I Do With My Home Equity Debt Under the New Tax Law?
Despite the fact that fewer expenses can be deducted on home equity loans and home equity lines of credit, these can still be useful financial tools with relatively competitive interest rates. Having the ability to access the equity in your property makes it easier to finance big-ticket expenses or consolidate other higher interest debts without having to resort to high-interest personal loans or credit cards. Don’t let the diminished tax benefit hold you back from considering a home equity loan or line of credit, especially if it's for a necessity that would otherwise have to be financed at a significantly higher rate.
Should I Refinance My Home Equity Loan to Make It Tax-Deductible Again?
Whether or not you should refinance your outstanding equity debt into your first mortgage will depend on your financial situation. If you were already planning to refinance your primary mortgage, then it may make sense to cash-out on the extra proceeds to eliminate your existing home equity debt altogether and consolidate your home loans under a tax-deductible primary mortgage. This also allows you to aggregate all of your mortgage debt into one simple monthly payment.
However, if you're considering refinancing your home equity loan for the sole purpose of reinstating the tax deduction on your mortgage debt; the closing costs incurred through refinancing will likely negate the tax savings for the majority of homeowners. Assuming you're able to secure a mortgage rate that is lower than your existing home equity loan, you'll want to balance the potential savings in tax deductions against the incremental closing costs incurred through a refinancing.
If the rate on your refinance exceeds your existing home equity rate, you'll need to tread carefully. Even a small increase in the interest rate on your primary mortgage could significantly increase your interest expense when amortized over several decades. Unless your home equity loan was used to purchase the home, this refinance will also most likely be considered a cash-out transaction, which will subject it to higher interest rates and a more stringent set of underwriting criteria.