Homeowners who itemize can still deduct interest paid on home-equity loans and lines of credit for a primary residence or a second home. But there are important caveats that have left taxpayers confused and frustrated.
I have received a flurry of questions from taxpayers on this topic recently, and, after talking to IRS spokesman Eric Smith, here are my answers to them.
Q: Does the new rule apply to existing home-equity lines of credit and loans?
It impacts existing and new home-equity loans. Starting this year and until the end of 2025, if you want to deduct any interest you pay on a home-equity loan, the money must be used to buy, build or substantially improve the property that the loan is secured against.
Let’s say you took out a $50,000 home-equity loan in 2016 to pay off a car and pay down some student debt. Unlike in previous years, the interest on that loan is no longer deductible.
And by “substantially” improve, the IRS means you are making capital improvements that add to the value of your home, such as adding a new bedroom or upgrading a bathroom.
Q: Will loan applicants be required to prove the money is being used for building or improving a home?
You may not be required to show proof when you file your return, but you better have it if you’re ever audited or questioned about the deduction.
Besides, when you sell your home, you don’t have to pay capital gains on the first $250,000 if you’re single. Married couples filing jointly can exclude $500,000. If you’ve made capital improvements, you can subtract those expenses from the sale to figure out how much, if any, capital gains you owe.
“You want to keep good records to show what you’ve done,” Smith said.
Q: What happens when people apply for and get a home-equity loan, but then suffer a financial crisis that prevents them from using the loan for its original purpose?
Generally, the money you borrow against your home can still be used for whatever you like. So if you set up a line of credit to fix your roof, but you lose your job and have to spend the money to put food on your table, you can do that. But you can’t deduct the interest paid on the loan.
However, under the new law, the standard deduction has been increased to $12,000 for individuals, $18,000 for heads of households and $24,000 for married couples filing jointly. Because more people will probably take the standard deduction, they won’t itemize such things as mortgage interest anyway.
“For a lot of people, the standard deduction will be high enough so that they won’t even be itemizing,” Smith pointed out.
Q: In 2017, I took out a home-equity loan to help my daughter with a down payment on her home. The plan is that in a few years, when she has built up equity, she will pay off my loan. Will I be able to deduct the interest on this loan in 2018, since the money was used in 2017?
Unless you paid off the loan in 2017, you cannot deduct the interest going forward. Again, the interest on new or existing home-equity loans is not deductible unless the money is used to buy, build or improve the home that secures the loan.
Q: We intend to use a line of credit on our vacation home to repair our primary home’s septic system. Would the interest be deductible?
In this situation, the interest would not be deductible, because the money would not be used for the home that secures the loan, which is the vacation property.
Q: I don’t believe the IRS has the inclination or the ability to check every home-equity loan. How will this law be monitored?
We have a tax system that is largely built on voluntary compliance. But some folks are banking on the fact that IRS audits are down. They’re willing to take the risk that the agency won’t detect their deception.
Cheat if you want. But I wouldn’t take the chance on lying.