Home Equity Loans and the Cap on Home Loan Tax Deductions

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Home Equity Loans and the Cap on Home Loan Tax Deductions

The Tax Cuts and Jobs Act (TCJA), which was signed into law on December 22, 2017, introduced major changes to the deductibility of mortgage interest. Most importantly, the amount of interest that may be deducted on eligible dwelling loans is now restricted to $750,000 for solo taxpayers and married couples filing jointly (or $375,000 for married filing separately), down from $1 million previously (or $500,000 for married filing separately).

Key Takeaways

  • The Tax Cuts and Jobs Act (TCJA) reduced the dollar limit on home mortgage interest deduction-eligible loans.
  • The maximum for single taxpayers and married couples filing jointly has been reduced from $1 million to $750,000 (or $375,000 for married filing separately, down from $500,000).
  • A eligible loan must be for a taxpayer’s primary or secondary residence.
  • Home equity loans, home equity lines of credit (HELOCs), and second mortgages, in addition to mortgages, qualify for the deduction if the sum of all loans does not exceed $750,000.
  • Under the new TCJA guidelines, home equity loan and HELOC interest deductions are only permitted if the loan is used to “purchase, construct, or significantly renovate” the house secured by the loan.

The Cap on Home Mortgage Tax Deductions

The amount of interest you may deduct on your tax return is determined by the date of the loan, the amount of the loan, and how you intend to utilize the loan proceeds.

Post–Tax Cuts and Jobs Act

Interest on house loans taken out on or after December 16, 2017 is entirely deductible if the loan amount is $750,000 or less for single filers and married couples filing jointly (or $375,000 or less if married filing separately). If the sum of your house loan exceeds this amount, the interest is only deductible up to the maximum. Furthermore, in order for the interest on a home equity loan or a HELOC to be deductible, the loan funds must be used to “purchase, construct, or significantly renovate” the house backing the loan. This tax legislation is in effect from 2018 through 2026.

Pre-Tax Cuts and Jobs Act

If you take up a house loan before December 16, 2017, but after October 13, 1987, the interest is entirely deductible if the loan sum is $1 million or less for single filers and married couples filing jointly (or $500,000 or less if married filing separately). If the sum of your house loan exceeds this amount, the interest is only deductible up to the maximum. However, interest on home equity loans or HELOCs is only deductible for tax years 2018 through 2026 if the loan funds are used to “purchase, construct, or significantly renovate” the house financing the loan, even if the loan was taken out before the legislation was approved.

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There is an exception: if you entered into “a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018,” and closed on the residence before April 1, 2018, you are “considered to have incurred the home acquisition debt prior to December 16, 2017.”

Legacy debt

There is no restriction on your home mortgage interest deduction if you obtained your loan on or before October 13, 1987. This legacy debt (despite its racial origins, the Internal Revenue Service still uses the word “grandfathered”) is entirely deductible if it was secured by your eligible house at any point after that date. Furthermore, there are no limits on using the funds to pay down legacy debt in order to qualify for the home loan interest deduction.

If you refinanced a loan secured by an eligible house after October 13, 1987, for an amount no more than the mortgage principal remaining on the debt, the refinance also qualifies as legacy debt.

Qualified Residence Loans

Loans secured by your main or secondary dwelling (also known as your qualifying residence) that do not exceed the applicable ceiling depending on purchase date may be eligible for the home mortgage interest tax deduction. Your principal mortgage, secondary mortgage, home equity loan, or HELOC are all examples of loans that qualify.

Since the passage of the TCJA, home equity loans and HELOCs are only eligible for the home mortgage interest deduction if the profits are used to “purchase, construct, or substantially renovate” the house secured by the loan and the total amount of all loans does not exceed the applicable maximum. If you utilize the proceeds of a home equity loan or HELOC for any other purpose, the interest deduction is stopped for tax years 2018 through 2026.

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Examples of Home Loan Tax Deductions

Here are some instances of when the house mortgage interest deduction is permitted and when it is not.

Fully deductible home equity loan

Sarah took out a $400,000 mortgage in January 2022 to buy her first house. She took out a $200,000 home equity loan in April 2022 to construct an extension to her house. In this case, Sarah’s total loan amount does not exceed the $750,000 ceiling, the usage of the home equity loan qualifies for the interest deduction, and both loans are secured by the principal residence. The interest is fully deductible.

Two fully deductible mortgage loans

Tom obtained a $300,000 mortgage in January 2022 to buy his main residence. He took out a $250,000 mortgage in May 2022 to buy a vacation property. Both loans are secured by the residences acquired with the proceeds, namely the main and vacation homes. In this scenario, Tom’s total loan value does not exceed the $750,000 ceiling, the loans are secured by the appropriate eligible dwelling, and all interest is deductible.

Not a deductible home equity loan

Jose took out a $300,000 mortgage in January 2022 to buy his $800,000 main residence. He took out a $250,000 home equity loan on his permanent residence in March 2022 to acquire a vacation property. The total amount of the loans in this scenario is less than the $750,000 maximum. However, the utilization of the home equity loan funds does not qualify for the tax deduction. The loan was utilized to acquire the vacation house and is secured by the principal residence. As a result, the interest paid on the home equity loan is not deductible.

Partially deductible mortgage loan

Kat obtained a $500,000 mortgage in January 2022 to buy her main residence. She took out a $400,000 mortgage in May 2022 to buy a vacation property. Both loans are secured by the residences acquired with the proceeds, namely the main and vacation homes. The loans in this scenario are secured by the right qualifying dwelling. The overall amount of the loans, however, exceeds the $750,000 limit. Only a portion of Kat’s total interest paid is deductible.

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Is interest on a home equity loan or a home equity line of credit (HELOC) deductible as a second mortgage?

It all depends. The interest paid on a home equity loan or a home equity line of credit (HELOC) is deductible only if the profits are used to “purchase, construct, or significantly renovate” the house that secures the loan. This implies that if you utilized the funds to cover personal living expenditures, you cannot deduct the interest.

Furthermore, you cannot deduct interest on a home equity loan taken out on your principal house to acquire a second home. The home equity loan funds must be utilized on the eligible house secured by the loan in order to qualify for the deduction.

I took out a home equity loan to pay off credit card debt. Is the interest deductible?

No, loan interest is not deductible if it is used to pay off personal obligations. The interest on a home equity loan is deductible only if the profits were used to “purchase, construct, or significantly renovate” the house that secures the loan.

How do I find my mortgage interest for the year?

On Form 1098, your mortgage lender will disclose the yearly amount of mortgage interest that you paid. When you get Form 1098, enter this amount on Schedule A, line 8a of Form 1040 to record your mortgage interest deduction.

The Bottom Line

Some home equity loans and HELOCs qualify for the mortgage loan interest deduction, but only if you fulfill the loan limit restrictions and utilize the loan for the approved reasons. Examine your deductions carefully to ensure that you are in compliance.

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