New Tax Rule Means Fewer Breaks for Home Equity Loans

Traditionally, a house has been a financial backup plan: If you wanted to help your children finance grad school, encountered a surprise medical bill or were tired of paying high interest rates on credit-card balances, tapping the equity in your home was a low-cost way to borrow. The interest rate on a home-equity loan or line of credit is often lower than what you’ll pay elsewhere, and you could deduct that interest on your taxes.

Not anymore. The 2017 tax legislation changed the rules, which may come as a surprise when you file your taxes this year. You can deduct interest on a home equity loan or line of credit only if the debt was to “buy, build, or substantially improve your home,” as the IRS puts it. If you borrowed for any other reason, the interest is no longer deductible.

Not only could this cost you money at tax time, but it could create a filing headache, since plenty of homeowners treat their homes like their personal banks. In a survey last fall by Bankrate.com, 44 percent of homeowners thought debt consolidation was a good use of home equity, while 31 percent cited education expenses. 

When you work on your taxes this year, if you’ve borrowed against your home for anything other than an improvement or repair, you'll need to get to know the IRS “tracing rules,” which require you to identify where the loan proceeds went. 

Your lender will send you the usual form stating how much interest you paid in total last year (Form 1098), but that bank or credit union has no idea what you did with the funds.

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To calculate your deduction, explains Mark Luscombe, principal federal tax analyst for Wolters Kluwer Tax & Accounting, you must track and document the portion used on your home vs. other projects. For example, if you spent 80 percent of the loan on a new kitchen and the other 20 percent on tuition expenses, say, you can deduct only 80 percent of the interest.

“The code allows you to estimate as long as it’s reasonable,” says Cari Weston, director of tax practice and ethics for the American Institute of Certified Public Accountants. 

It’s not exact tracing, Luscombe adds. “You don’t have to prove those exact home equity funds went to improvements, but you need to document how you spent $100,000 on a new bedroom.”

Finally, you can’t get around this by refinancing your original mortgage and rolling your home equity loan into that or taking out cash to spend however you please: The new rule for deducting interest applies to all debt backed by your home, notes Luscombe. 

Plus, you could run afoul of another new limit on deducting home loan interest: Unless you borrowed before Dec.15, 2017, you can no longer deduct interest on home debt in excess of $750,000, down from $1 million (that’s still the limit on older loans). 

Given all of these changes, notes Weston, “you may be better off simply paying down the debt.”