Property values have been soaring in the past few years and homeowners are starting to gain equity back in their homes. In the 1990’s and early 2000’s this kind of environment created a boom for the home equity lending market. However, a new provision of the Tax Cuts and Jobs Act of 2017, which puts limits on mortgage interest deductions for home equity debt, is making many borrowers reconsider the advantages of tapping into their home equity. Let’s take a closer look at what’s actually changed.
First, it is important to understand what the mortgage interest deduction is. The mortgage interest deduction allows a homeowner to deduct the interest paid on their home loan from their taxable income—which lowers their overall effective tax rate. The deduction has been a boon for homeowners and is credited by many for helping create the “American Dream” and incentivizing home ownership.
Mortgage acquisition debt is defined by the IRS as a loan used to buy, build, or substantially improve a property—often the primary loan a homeowner takes out to buy their home. Home equity debt is a secondary loan in which a homeowner borrows against the equity in their home—which could be used to build an addition or other improvement, but could equally be used to pay off credit card debt or student loans, buy a car, or for any purpose unrelated to the property.
Before 2018 a homeowner could deduct the interest of any home equity loan up to $100,000—regardless of how they used the funds (paying off student debt, car loan, etc.). But, the Tax Cuts and Jobs Act of 2017 only allows home equity debt to be deductible if it’s used to make “significant improvements” to your home. Additionally, (and you’ll see how this impacts home equity loans as well) the Tax Cuts and Jobs Act of 2017 also reduced the mortgage interest deduction cap for primary loans from $1,000,000 to $750,000.
Essentially the only way to deduct home equity debt now is for it to qualify as acquisition debt—funds used to buy, build, or substantially improve your property—even if the debt itself is a home equity loan. No more deductions for using home equity cash for paying off student loan debt, credit cards, or other expenditures. What’s more, a homeowner’s primary mortgage amount + deductible home equity loan can’t go over the new $750,000 threshold.
If you purchased a home for $500,000 and decide to take out a $250,000 home equity loan to build on a new addition, the interest on both mortgages would be tax deductible. However, if you used the $250,000 to pay off personal loans, not secured to your primary residence, the amount would not be tax deductible.
Although home equity loans have long been utilized to pay down personal items (credit lines, auto loans, etc.)—these and all home equity transactions (even those used to build, buy, or improve) were capped at the $100,000 loan amount to receive a mortgage interest deduction.
Now, if you bought a home with a mortgage of $600,000 five years ago, and take out a home equity loan for $125,000 to put on a new addition (home equity debt that’s classified as acquisition debt), the entire $725,000 is tax deductible because it falls under the $750,000 threshold.
In Q4 of 2017, the percentage of homeowners’ equity rose to levels we haven’t seen since 2006. With this type of uptick, and the clarification from the IRS on what type of debt is still tax deductible, it is very likely that borrowers will still tap into their home equity to make improvements or cover unforeseen repairs on their home. For this subset, home equity loans are still a viable resource to turn illiquid assets into liquid, spendable, tax-deductible cash.
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