INSIGHT: Home Equity Interest May Still Be Deductible

On Dec. 22, 2017, H.R. 1, originally known as the Tax Cuts and Jobs Act, Pub. L. No. 115-97, was signed into law. The new law includes substantial changes to the taxation of individuals and businesses of all sizes. Among these changes, certain aspects of an individual’s deduction for home equity interest have been temporarily modified.

For tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, an individual’s deduction for qualified residence interest expense has been amended to disallow a deduction for interest on “home equity indebtedness.” However, when it comes to home equity lending and borrowing, there is more than meets the eye for purposes of this deduction. “Home equity indebtedness” is a specifically defined term, and to the extent certain criteria are met, a taxpayer may still be able to deduct interest paid on a home equity loan, home equity line of credit, second mortgage, or similar product.

Background

Both acquisition indebtedness and home equity indebtedness are defined terms within the Internal Revenue Code. Thus, for a full understanding of what changed as part of tax reform legislation—and more importantly what is deductible—it is helpful to understand the tax definitions of several terms.

A “qualified residence” is:

• The taxpayer’s principle residence; and
• Any other residence owned and used as a residence by the taxpayer that is selected by the taxpayer to be a qualified residence.

And “home equity indebtedness” is any indebtedness, other than acquisition indebtedness, secured by a qualified residence. So, to understand the meaning of home equity indebtedness, we must look to acquisition indebtedness.

“Acquisition indebtedness” is any indebtedness secured by a qualified residence of the taxpayer that is incurred in:

• acquiring;
• constructing; or
• substantially improving

any qualified residence of the taxpayer.

Acquisition indebtedness also includes any indebtedness secured by any qualified residence that is incurred to refinance acquisition indebtedness (limited to amount of the indebtedness refinanced at time of loan).

Acquiring means to buy a home within 90 days before or after the date indebtedness is obtained. In the case of construction, a taxpayer may treat a residence under construction as a qualified residence for a period of up to 24 months, provided it becomes a qualified residence as of the time it is ready for occupancy. The taxpayer may take out indebtedness within 90 days after work is completed, but acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before work is completed and ending on date of the indebtedness.

When substantially improving a property, a taxpayer may take out indebtedness within 90 days after work is completed, and acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before work is completed and ending on date of the indebtedness. Furthermore, an improvement is substantial if it adds to the value of the home, prolongs the home’s useful life, or adapts the home to new uses. Examples of substantial improvements include: replacing a roof, remodeling a kitchen, or building a new addition. However, repairs that merely maintain a home in good condition (e.g., repainting the home) are not substantial improvements. However, if a home is repainted, for example, as part of renovation that otherwise substantially improves home, the painting costs may be included in cost of improvements.

Other uses of funds from a home equity loan, such as buying a car or buying a standalone microwave, are not acquisition indebtedness.

Consider the simple example of a taxpayer with no prior indebtedness taking out a $500,000 mortgage to purchase a principal residence. Because the loan was used to purchase a home and is secured by the home, the loan is acquisition indebtedness. Continuing the example, assume this same taxpayer later takes out (1) a $50,000 home equity loan to add a room to the first house, and (2) a separate $300,000 mortgage to construct a vacation home. The $50,000 loan is acquisition indebtedness because the proceeds were used to substantially improve the first home. The $300,000 loan is acquisition indebtedness because the proceeds were used to construct a home, and the taxpayer is permitted to treat one other home as a qualified residence in addition to the principal residence. If the taxpayer later takes out another $50,000 home equity loan to purchase a car, this loan would not be considered acquisition indebtedness because the proceeds were not used to purchase, construct, or substantially improve a qualified residence. Instead, this loan would be home equity indebtedness.

Prior Law, Tax Reform, and What Really Changes

Generally, an individual is not permitted a deduction for personal interest expense unless a specific exception applies. Prior to the legislative changes from tax reform in Dec. 2017, taxpayers were permitted a deduction for interest on “acquisition indebtedness” of up to $1 million and on “home equity indebtedness” of up to $100,000. A deduction was allowed for mortgages on a primary residence and one other home, but the dollar limitations remained the same whether being applied to one home or combined for two homes.

Under the new tax law, for tax years 2018 through 2025, the deduction for acquisition indebtedness interest is limited to debt of $750,000, although debt incurred on or before Dec. 15, 2017, is grandfathered as subject to $1 million limitation. Additionally, the deduction for home equity indebtedness is suspended through 2025.

Although no deduction will be permitted for interest on home equity indebtedness for tax years 2018 through 2025, the specific definitions of acquisition indebtedness may nonetheless permit taxpayers to deduct interest on debt products commonly referred to as home equity products. Therefore, as a result of the change in the tax law, it is important to determine a few key facts regarding home-related indebtedness.

Specifically, a taxpayer must ask: Was the debt used to acquire, construct, or substantially improve the qualified residence? If the answer is “yes,” then it is acquisition debt, regardless of the name applied to the loan (home equity loan, home equity line of credit (HELOC), second mortgage, etc.). In these instances, the interest paid on the loan would be deductible, subject to the limitations discussed above.

In many situations, the deductibility of home equity interest is not necessarily affected. Consider a taxpayer with no indebtedness except an existing mortgage balance of $700,000 secured by a primary residence purchased with the proceeds from the mortgage. The taxpayer then takes out a home equity loan for $50,000, secured by that same residence, to “substantially improve” the residence by building an addition. The taxpayer’s interest on both loans will remain deductible under the new law because the total amount of indebtedness does not exceed $750,000, and both loans represent acquisition indebtedness.

Consider the same facts as above, except that the taxpayer instead used the proceeds from the $50,000 loan to purchase a vehicle. Under prior law, the interest on this home equity loan would still have been deductible home equity interest. However, the interest on the loan would no longer be deductible for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, because the loan proceeds are not used to acquire, construct, or substantially improve the residence.

Impact on Home Equity Lending

After the initial shock of seeing a disallowance for “home equity indebtedness,” it appears that many uses of these funds may still provide for a proper interest deduction. Furthermore, in a January 2018 survey conducted by Accurate Group, 77 percent of responding lending executives expected minimal or no impact from tax reform on home equity lending applications. See Accurate Group, Home Equity Tax Law Impact (March 2018). However, a majority of respondents indicated they expect borrowers to pay off or reduce existing balances faster. Notably, nearly 97 percent of respondents indicated a belief that the tax deductibility of interest is not the most significant influence on a borrower’s decision to apply for a home equity loan.

“Based on our survey of banks, credit unions and other home equity lenders and our dialog with the top home equity lenders at the Consumer Bankers Association annual CBA Live conference in March 2018, we believe the demand for home equity loans and HELOCs will remain strong,” stated Paul Doman, president and CEO of Accurate Group. “Recent IRS clarification allayed many of the initial concerns lenders had about the impact of the new tax law on home equity lending, and demand for our home equity appraisal, title and closing solutions remains strong so far this year—an indicator that lenders are continuing to grow that portion of their business.” Email from Paul Doman, president and CEO of Accurate Group.

Ultimately, the determination of whether interest on a loan is nondeductible “home equity indebtedness” interest or deductible “acquisition indebtedness” interest is a facts and circumstances analysis, but the key takeaway for taxpayers is that not all deductibility is lost for interest on home equity debt products under the new tax law.

Liz L’Hommedieu is a principal and Chris Stroeer is a senior associate in the Financial Institutions and Products group of KPMG LLP’s Washington National Tax practice.

The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.