The new tax law commonly referred to as the Tax Cuts and Jobs Act (TCJA) curtailed personal tax deductions for mortgage interest. While interest deductions on new borrowings are subject to a lower ceiling, interest on home equity loans is now disallowed altogether. However, a closer look is necessary to prevent taxpayers from being short-changed.
For new amounts of acquisition indebtedness incurred after Dec. 15, 2017, taxpayers may treat only $750,000 of such indebtedness as eligible for the mortgage interest deduction. Acquisition indebtedness incurred on or before Dec. 15, 2017 remains subject to the former $1 million deductibility thresholds. Additionally, the deduction of interest on up to $100,000 of home equity indebtedness is disallowed for tax years beginning after Dec. 31, 2017, regardless of when such indebtedness is incurred. Because the determination of what constitutes home equity indebtedness is an exercise extending beyond the mere labelling of such loans as home equity, it is important to categorize it correctly in order to claim potentially deductible interest.
Home equity indebtedness is defined under TCJA using the same definitions contained in the prior as law. TCJA revised the law to eliminate this deduction for 2018 through 2025 by stating merely that a deduction of interest meeting the home equity indebtedness definition “shall not apply” for those years. Thus, the disallowed deduction applies to any indebtedness that is currently home equity indebtedness as defined in §163(h)(3)(C):
The term "home equity indebtedness" means any indebtedness other than acquisition indebtedness (debt incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer that is secured by the residence) secured by a qualified residence to the extent the aggregate amount of such indebtedness does not exceed—
- The fair market value of such qualified residence, reduced by
- The amount of acquisition indebtedness with respect to such residence.
It is important to note that the nature of indebtedness follows these definitions, and that the labelling or naming of such indebtedness is irrelevant. For instance, debt that is labelled as a Home Equity Line of Credit (HELOC) but otherwise meets the definition of acquisition indebtedness will be treated as acquisition indebtedness. If the debt meets the definition of "acquisition indebtedness," the interest will be deductible regardless of whether it is a second mortgage or a HELOC. However, interest on any debt that meets the "home equity indebtedness" definition will not be deductible in 2018-2025.
The IRS confirmed this result in News Release IR-2018-32, Interest on Home Equity Loans Often Still Deductible Under New Law. The article provided several examples, reproduced below, to illustrate this point.
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.
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.
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 (see Publication 936).
Having established that interest on debt labelled as a home equity loan is still potentially deductible, the next question is whether the interest tracing rules would allow such debt used to fund the purchase of stock or other investment property to be deducted as investment interest. Extending the above findings that the underlying character of the loan and the use of the loan proceeds determines the characterization of the interest expense leads to the question of whether the investment interest deduction and the interest tracing rules were altered by TCJA.
TCJA did not change the Code or regulations pertaining to investment interest expense. Moreover, the law provides that investment interest is not considered nondeductible personal interest, and the regulations allow a taxpayer to elect to treat debt secured by a taxpayer’s qualified residence as debt not secured by the taxpayer’s qualified residence. This election effectively shifts the taxpayer to the interest tracing rules, under which the taxpayer can deduct any interest paid on the debt if the proceeds were used to generate income in a qualifying activity, such as in a trade or business or to generate investment income.
As a result, taxpayers may deduct interest on a home equity debt as investment interest, subject to the investment interest limitations, if the proceeds were used to purchase stock or other property used to generate investment income and the taxpayer makes the election to treat the secured debt as debt not secured by the taxpayer’s qualified residence. The next step is to then determine the allocation of the interest under the interest tracing rules.
Under the interest tracing rules, it is simple to determine the allocation if the borrowed funds are segregated into individual accounts or if the borrowed funds are paid directly to the seller of property or a single service provider. In these simple situations, the specific use of the funds determines their treatment. A more common scenario is that the borrowed funds are comingled with funds from other loans or with unborrowed funds in a single account. In these instances, the regulations provide a series of allocation rules to match the borrowed funds with expenditures. These rules must be applied separately to each account:
- If borrowed funds and un-borrowed funds are comingled within a single account, the presumption is that the borrowed funds were spent first.
- If borrowed funds from more than one loan are deposited into a single account, then the borrowed funds are presumed to be expended in the order the loans were received (i.e., the proceeds of the earliest loan are deemed to have been spent first).
- However, if the loan proceeds from multiple loans are deposited simultaneously into a single account, they are treated as deposited in the order in which the debts were originally incurred, and if such debts were also incurred simultaneously, then the taxpayer can choose the order the funds were deposited into the account.
- With the exception of the 30-day rule (item 7), expenditures will not be allocated to borrowed funds if the expenditure occurred before the loan proceeds were deposited to the account.
- The collateral for the debt is generally irrelevant though special rules apply for qualified residence interest expense and interest is not deductible if the loan is secured by an obligation generating tax-exempt interest, or secured by a single premium annuity contract.
- Borrowed funds that remain unspent are presumed to be held for investment. When the funds are spent, they are re-characterized according to the nature of the expenditure. For purposes of re-characterization, the taxpayer may treat expenditures as having occurred on the later of the first day of the month the expenditure was made, or the date on which the loan proceeds were deposited.
- If an expenditure is made within 30 days before or after the loan proceeds were deposited the taxpayer can treat the expenditure as made from the borrowed funds. This overrides the result that would occur under the normal rules, and this 30 day period is extended to 90 days if the debt qualifies as acquisition indebtedness under the mortgage interest rules.
In summary, interest on loans labelled as home equity may still be deductible. The answer depends on the taxpayer’s use of the debt proceeds, which can be determined presumably under existing regulations that provide interest tracing rules. Such interest may be traced to acquisition indebtedness (potentially deductible as home mortgage interest), investment interest, or trade or business interest. An analysis of these rules is necessary to maximize the deduction of interest expense. For more information concerning these rules, please contact your local CBIZ MHM tax professional.
Copyright © 2018, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).