Wrapping up Blog Postings on Interest on HELOCs and home equity loans often still deductible under new law by Tim McTaggart
As noted in several prior blog postings by me on McTaggart legal.com and LinkedIn, on February 21, 2018, in IR-2018-32, the IRS advised taxpayers that "in many cases they can continue to deduct interest paid on home equity loans." And, the same is true for HELOCs. As noted by the Service, "The Tax Cuts and Jobs Act of 2017, enacted December 22, (2017), suspends from 2018 until 2026 the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer's home that secures the loan." The IRS also noted that "Under the new law, for example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not." That is a change from prior law when such personal living expenses could qualify for tax deduction under home equity loans or HELOCs. To be clear, under the new tax law, the home equity products can still be used for paying for personal living expenses which is not restricted but tax deduction will no longer be available to incentivize the use of home equity products to, for example, purchase a car.
Additionally, the new law applicable to the 2018 tax year, "imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residences. The limit is $375,000 for a married taxpayer filing a separate return. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer's main home and second home." That is a change from prior law and is largely self-explanatory for new mortgages entered into after December 2017. For existing mortgages in place prior to December 2017, the prior limits of $1 million and $500,000 as noted above are grandfathered restrictions which are more flexible and generous than what is allowed under the changed law.
The additional change under the new law which is not directly addressed in the IRS advisory release is that previously the amount of borrowing under home equity products was capped at $100,000 for purposes of qualifying for a tax deduction. That $100,000 cap is eliminated under the new law and instead the borrowing under the home equity products must fit within the requirement to buy, build or substantially improve the taxpayer's home that secures the loan. Interestingly, since the new law permits deductibility of up to $750,000 in total mortgage indebtedness, it is possible that a taxpayer could enjoy more flexibility to deduct interest on home equity products that exceed the prior $100,000 cap provided that the overall mortgage indebtedness for the taxpayer remains below $750,000. Moreover, even if the total mortgage indebtedness exceeds $750,000, as you will see momentarily, the IRS provides a mechanism to pro rate the level of mortgage indebtedness so that mortgage interest should be fully deductible on mortgage indebtedness up to the $750,000 cap amount.
The IRS provided three examples to illustrate the points that it summarized in IR-2018-32. In previous blog postings to which I refer you to on my site, I reviewed the first two IRS examples. This last blog posting on this IRS guidance will review the Example 3 provided by the IRS.
Specifically, the IRS noted:
"Example 3. 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)."
Publication 936 provides further information and a schedule with computational inputs, and instructions, to ascertain the percentage of the total interest that is permissibly deductible. In general, the taxpayer needs to take the amount of the indebtedness cap, here it is $750,000, and divide by the amount of the total indebtedness, here it is $1,000,000 and take the resulting amount, to three decimals, which in this case is .750 or simply, 0.75, or 75%. So, it is not stated in the IRS example 3, but the apparent result should be that up to 75% of the total amount of mortgage interest paid related to the $1 million total indebtedness should be tax deductible.
While I have not further researched this next point, there would appear to be some simplification processes imposed by the IRS as part of the Example 3 scenario and there might be technical changes considered by a taxpayer or its adviser depending on the facts and circumstances. For example, the calculation is done by applying a percentage to the total amount of interest paid which implicitly assumes that the interest rate is the same for both mortgage products. The interest rates are likely to be comparable, but generally the home equity products likely have a higher interest rate. So, in some instances, it might be more economically advantageous to the taxpayer to just count the amount of the interest associated with the higher level of home equity products, or second mortgage, and disclaim the lower amount of interest related to the first mortgage products. However, that does not appear to be possible under the IRS methodology where the total indebtedness needs to be summed up and likely it is not possible to disclaim, for example, any first mortgage amount once the $750,000 cap level is met solely or mainly by the home equity product or by the second mortgage levels.
Additionally, while this blog posting is not intended to provide legal or tax advice since the particular facts and circumstances are critical to analyze possible outcomes, I once again would caution banks and financial institutions to not place erroneous ads in print or other marketing literature which suggests that HELOCs and home equity loans are no longer deductible under the the new law. Likewise, I would be happy to discuss in more detailed private conversations what no one seems to completely know concerning when there might be a UDAP or UDAAP concern raised by financial institutions offering, marketing, administering, and interacting with current and potential clients regarding home equity products particularly if there are possible false or misleading claims made about the tax status of home equity products. There remains a fair amount of confusion by bank management about the implications of correctly marketing home equity products through traditional financial service platforms and increasingly now through ecommerce/fintech platforms.
Timothy McTaggart
timothymctaggart944@gmail.com