Changes on the Homefront: Deducting Home Equity Interest Under the Tax Cuts and Jobs Act of 2017

One of the key tax benefits of owning a home is the ability to deduct mortgage interest. No worries, under the Tax Cuts and Jobs Act (TCJA) of 2017, you can continue to do so.

The rules state that in 2018 and going forward, you can deduct the interest on a home mortgage of $750,000 or less (this must be your principal residence). This is a change from the previous $1 million limit.

Changes have also occurred when it comes to deducting home equity interest. A home equity line of credit (HELOC) is when you borrow money against your mortgage.

Let’s cut to the chase. If you take out a home equity loan in 2018, and use the funds for personal use…deducting home equity interest is not allowed. The tax law is very clear on this. Personal use could be purchasing a car or paying off other debt.

However, there are 3 ways of deducting home equity interest on your tax returns. The first is if you use the equity line towards improving your principal residence. The second? If the equity loan is used for business purposes. And finally, if you’re using that line of credit to purchase a rental property, you can still enjoy the tax advantages of deducting home equity interest.

Now, we’ll take a closer look at deducting home equity interest.

 

Scenario #1) Deducting Home Equity Interest When Improving Your Principal Residence

This scenario is similar to one outlined by the IRS themselves when clarifying the TJCA rules on deducting home equity interest.

Lisa takes out a $400,000 mortgage loan in 2018 to buy a home (it will be her principal residence). The market value of the home is $600,000. Later in the year, she takes out a home equity loan of $100,000.

Lisa will be using all of the $100,000 to get a new roof and update the garage. When it comes to deducting home equity interest on her tax returns, Lisa is good to go. Why? Because 100% of the home equity loan is going to be used for improvements. If Lisa uses even $10,000 of that loan for personal purposes, she’s out of luck in deducting home equity interest on that $10,000 (but she can still take the deduction on $90,000).

Another way that Lisa is “safe” when deducting home equity interest is because the total amount of borrowed money is under $750,000. The $400,000 mortgage plus the $100,000 home equity loan are $500,000. The total money Lisa borrowed on her home also does not exceed its fair market value ($600,000).

It’s important to note that the definition of “home improvement” does not include purchasing items that make life better for you. No, that 72” hi-def TV or leather sofa is not a home improvement. If you aren’t sure if the expense is truly a home improvement, get advice from a reputable CPA before doing the work.

 

Scenario #2) Deducting Home Equity Interest When the Equity Loan is Used for Business Purposes

Ben has always wanted to start his own business. He decides to take out a home equity loan of $100,000 on his principal residence. He will be using 100% of that loan to fund his startup business. When it comes to deducting home equity interest, he is all set! Ben will report the interest as a business expense on his 2018 tax returns.

Deducting home equity interest for business purposes is one of the best ways to reduce your qualified business income (QBI). By the way, in 2018, your business may also be eligible for a 20% QBI tax deduction – view the link to see if you qualify.

There’s another benefit of taking out a home equity loan to start a business. Typically, home equity loans come with lower interest rates than commercial loans.

Already have a business? Deducting home equity interest also works to your advantage. Use the funds to improve your facility, invest in equipment, anything that’s related to your business.

In fact, you could utilize a home equity loan to simply provide cashflow to your existing business! If you have a cyclical business, that money could be used to offset slow times of the year.

 

Scenario #3) Deducting Home Equity Interest When Purchasing a Rental Property

 

Last but not least, you could be deducting home equity interest in 2018 if you take out a line of credit on your principal residence to purchase a rental property.

Be careful here. If you use the home equity loan to purchase a vacation or second home, you should not be deducting home equity interest on your tax returns. Yes, things do get tricky if you plan to rent out that vacation home. Talk to a CPA before moving ahead.

So, let’s wrap things up. If you take out a loan on your home’s mortgage in 2018 and intend to use it for one of the 3 purposes listed above, you should be safe when deducting home equity interest on your 2018 tax return.

However, in the event of an audit, you will need to prove that 100% of the home equity loan was used for an allowable purpose. Keep all of your receipts, contracts, and detailed proof that you used the funds properly. There is no substitute for solid recordkeeping.

Deducting home equity interest can be a great way to reduce your taxable income. Beyond that, if you use the loan for business purposes or a rental property, you’re investing in your future.

Be smart. Do your research on deducting home equity interest in 2018. And as always, consult with an accountant to understand your options – and to find your best tax posture.