In News Release IR-2018-32 the IRS sought to deal with what appears to be a widespread misunderstanding of how the home mortgage interest deduction works under the revisions passed as part of the Tax Cuts and Jobs Act.  The IRS points out that merely because a lender refers to a loan as a “home equity” loan, that does not mean the interest will not be deductible in 2018, so long as proceeds of the loan are used to acquire or substantially improve the residence.

Under IRC §163(h)(3)(F), only “acquisition indebtedness” (as defined by IRC §163(h)(3)(B)) will be deductible, and “home equity” indebtedness (as defined by IRC §163(h)(3)(C)) will not be.  Too many taxpayers, reporters and, in this author’s experience, even tax advisers are ignoring the “as defined by” clauses above and instead go directly to using loan labels to determine deductibility.

That has led many to believe that any loan that is labeled by the lender as a home equity loan will automatically fail to qualify for a deduction for any of the interest paid on the loan in 2018.  That is simply a false statement.

Rather, it is important to recognize that the definition of “home equity” debt is radically different under the Internal Revenue Code than that used by lending institutions or in common parlance.

Under IRC §163(h)(3)(B), acquisition indebtedness (the type that qualifies for a deduction, subject to limits on the amount of the debt) is any debt no matter how it is labeled that meets the following two criteria:

• The debt incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
• The debt is secured by such residence.

As well, acquisition indebtedness includes “any indebtedness secured by such residence resulting from the refinancing of indebtedness” that met the criteria to be acquisition debt “but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.”[1]

What the IRC calls “home equity” debt at IRC §163(h)(3)(C) is simply any debt secured by the residence that fails to meet the acquisition debt criteria.

As the IRS news release properly notes:

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. As under prior law, the loan must be secured by the taxpayer’s main home or second home (known as a qualified residence), not exceed the cost of the home and meet other requirements.

The news release contains the following three examples of applying the home mortgage interest rules after the changes made by the Tax Cuts and Jobs Act:

Example 1: 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.  

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. 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.

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).

[1] IRC §163(h)(3)(B)