Tax Loophole for Deducting Home Equity Loan Interest

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a slew of new tax breaks while doing away with several others. Some of the tax changes directly affected taxpayers who own a home or plan to purchase one.

One of the eliminated measures changed tax benefits for home equity loan interest. Much of that deduction was effectively eliminated—at least through the end of 2025. However, the Internal Revenue Service (IRS) left a loophole in the current tax law that permits some homeowners to continue benefiting from the home equity loan interest deduction, but only if they meet certain criteria.

Rules for Deducting Home Equity Loan Interest

The changes introduced under the TCJA include a reduction of the cap on the mortgage interest deduction. The deduction can be claimed only for the interest paid on mortgage debt up to $750,000 if the loan was taken out after Dec. 15, 2017. The previous limit was $1 million. This cap also applies to home equity loans, home equity lines of credit (HELOCs), and second mortgages, but only under specific circumstances.

In February 2018, the IRS issued an advisory memo for taxpayers regarding the status of the home equity loan interest deduction under the new set of tax laws. This memo specified that interest on home equity loans, HELOCs, and second mortgages still might be deductible, as long as the loan is for an IRS-approved use. Specifically, these loans must be used to “buy, build or substantially improve the taxpayer’s home that secures the loan” for the interest to be deductible. Prior to the TCJA, there were no restrictions on how homeowners could use funds.

While the IRS did not include a list of expenses that would be covered under the law’s provisions, their advice did include some examples of allowable home improvement expenses, such as building an addition to your home. Other purposes that qualify for the deduction if you’re using a home equity loan or a HELOC include:

• Putting a new roof on the property
• Replacing your HVAC system
• Completing an extensive kitchen or bathroom remodeling project
• Resurfacing your driveway

Best Practices for Claiming the Home Equity Interest Deduction

If you own a home and are planning to claim the home equity loan interest deduction, there are a few things to remember. First, the money must be used for home improvements or renovations. For example, you cannot take the deduction if you are using home equity proceeds to pay for personal expenditures or consolidate credit card debt. The same goes if you are taking out a loan and letting the money sit in the bank as your just-in-case fund for emergencies.

What’s more, the renovations have to be made on the property on which you are taking out the home equity loan. You cannot, for example, take out a loan on your primary residence and use the money to renovate your cottage at the lake.

Next, keep proper records of your expenses. The odds of being audited by the IRS are generally low, but you do not want to take any chances. If you’re planning to use a home equity loan or HELOC to pay for home repairs or upgrades, be sure to keep receipts for everything you spend and bank statements showing where the money went.

Finally, remember that this deduction is not unlimited. You can deduct the interest on up to $750,000 in home loan debts, if the loans were made after Dec. 15, 2017. If your total mortgage debt is higher than that, you won’t be able to deduct all of the combined interest paid. The $1 million cap applies for mortgages obtained before that date. As interest on older mortgages retains a legacy to $1 million loans, check carefully with a tax professional about what you can deduct if you have both an older mortgage and a home equity loan that qualifies for deductions.

The Bottom Line

A home equity loan or a HELOC can be a convenient source of funding when you want to spruce up your home. Snagging a tax deduction for the interest that you pay is an added perk. As with any other loan, however, take the time to compare interest rates and loan terms from different lenders to find the best deal possible.