Banks need new insight on HELOCs and home equity loans by Tim McTaggart
As noted in an earlier blog posting, the IRS on Feb. 21, 2018 announced in IR-2018-32 that, interest on home equity loans often still deductible under new law--namely the Tax Cuts and Jobs Act of 2017, enacted on Dec. 22, 2017. Of course, it will be in 2019 in connection with filing the 2018 returns that taxpayers/borrowers will possibly run into new issues with their product lines and come back to their lenders seeking some type of explanation/resolution of the matter.
This blog article does not constitute the provision of tax or legal advice. Please contact me or another one of your advisers with your specific circumstances to determine the tax and/or legal consequences of actions that banks have taken in connection with these lending products as well as the impact/effect on taxpayers/borrowers. Plus, there is an administrative recordkeeping burden on banks along with taxpayers/borrowers.
So, why did the IRS say home equity loans are often, but not always, deductible under New Law? Well, it is because there are still some traps embedded in the law some of which bring forward requirements that were in place under prior law and some of which require close attention under the New Law.
As noted in an earlier blog posting on this topic, the IRS provided three examples to illustrate its points about these products and the New Law. The previous blog posting reviewed Example 1 from the IRS. This blog posting will review Example 2 from the IRS. A future blog posting will review Example 3.
So, the IRS noted in its Example 2: "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. " The "teaching lesson" that the IRS is hoping to impart is the importance of the respective loans being secured by the taxpayer's main home and second home, respectively.
The IRS underscores this point by further noting in Example 2 that, "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." That seems pretty clear but it is overly simplistic and probably does not touch the circumstances of many bank clients. For example, mortgage interest that is related to business activities should likely be deductible as a business expense. That raises the question of whether it matters where the loan is sourced from. So, if the loan is from a main residence HELOC which is used exclusively for business purposes for an investment property including a vacation home/second home, then is the mortgage interest deductible as a business expense? It is not a personal deduction but it still may have a tax component to the borrowing. Likewise, what if the borrowing is not secured by the vacation/second home but it is used for business, does it mean that the interest is still deductible for business purposes? Also, keep in mind that there are still strict limitations on an owner's personal use of a second home/vacation home which is being used principally as an investment property.
Of course in the IRS example if the home loan on the second home/vacation home were a HELOC/home equity loan secured by the second home/vacation home property, instead of a purchase loan, that likely should be ok, too under the IRS reasoning and rationale.
Bank executives and boards should be reviewing their institutional marketing materials and related collateral documents to make sure that the text and related media images are "up to date" regarding the uses of HELOCs and home equity loans. There also needs to be additional training of compliance and front line staff on these matters plus a review of the administrative support that the bank is prepared to provide to its customers as those customers realize that the rules require tracking of the use of these products in new ways.
Tim McTaggart