In the past, you might have taken out a home equity loan or line of credit for something unrelated to home improvement in order to take advantage of the tax savings. Prior to 2018, interest paid on a home equity loan up to $100,000 was fully tax deductible, no matter what you used it for. That meant you could use a home equity loan to, for example, pay off high-interest credit card debt and deduct all the interest expenses on your taxes.
That’s no longer the case. While you may still be able to deduct your home equity interest, it’s not the blanket deduction it used to be. Let’s examine what actually changed with mortgage interest when the 2017 Tax Cuts and Jobs Act (TCJA) took effect. The TCJA affected a lot more than just mortgage interest, but that’s the part of the act we’ll focus on today.
There were two main updates to how you can deduct loan interest secured by your home:
- Previously, mortgage interest was deductible on the first $1 million of mortgage debt. That limit still holds for homes grandfathered in before the cutoff date, but if you bought your house after December 15, 2017, you’re limited to deducting interest on the first $750,000 of mortgage debt.
- Under the old law, home equity interest was automatically deductible on up to $100,000 of debt. Under new law, the money you borrow needs to meet two requirements for you to deduct the interest you pay on the loan:
- The home equity loan or line and your mortgage combined must be under the $750,000 mortgage debt limit.
- You must use the money borrowed to make capital improvements to your house.
What interest can I still deduct?
If the mortgage on your primary residence is $750,000 or more, you’re already at the limit and won’t be able to deduct any home equity loan interest on your taxes. But what if your mortgage is grandfathered into the $1 million limit? Spending the money from the home equity loan or HELOC after December 15, 2017 makes the lower limit apply.
Let’s say you’re under the limit, though. What about the second requirement that the money is used to improve your house? This is where it starts to get murky. The IRS defines these home improvements as something that adds to the market value of your home, prolongs its useful life, or adapts it to new uses. What’s not included are home repairs and maintenance. So, building an addition for a new bathroom is a capital improvement. Fixing a broken window would be a maintenance expense.
But what if when you fix the broken window, you replace it with a newer, energy efficient window? Is it a capital improvement or a maintenance expense? That’s the gray area. If you’re not sure whether an improvement qualifies, your best bet is to consult a tax professional for a second opinion.
My expenses meet the requirements, now what?
So, your loans are under the $750,000 threshold and you used your home equity loan or line to make capital improvements to your property. What form do you submit with your taxes to prove it?
The form you’ll file to show the interest paid in the prior tax year is a 1098 tax form. The form doesn’t break down eligible interest vs. ineligible interest, though. The IRS leaves that up to you.
“Does that mean I can just deduct ALL the interest I paid last year?” you ask. Well, no. If it wasn’t all from eligible expenses, that would be tax fraud and a very, very bad idea. You may not be asked to prove the validity of your expenses when you file, but if your return looks fishy and you get audited, they’ll want to see receipts. Keep as much documentation of your home improvement project as you can: receipts, descriptions of work done, before and after photos … anything that helps prove that the money you spent was used for capital improvements.
Do home equity loans still make sense?
If you plan to use it for value adding home improvements and can write off the interest, absolutely. If you’ll be using the money for something else, you should consider whether a home equity loan or a personal loan will be a better fit.
Generally, home equity loans or lines of credit have longer terms and lower interest rates, while personal loans and lines have shorter terms and higher interest rates. What does that mean? For the same amount borrowed, you’ll have a lower monthly payment with a home equity but be paying it off for much longer. A personal loan, with terms rarely extending longer than 84 months, has much less time for interest to accrue, so even though the rate is higher, the total interest paid will likely be less.
Still not sure which is a better fit for your situation? We’ve dug into the question of personal loan versus home equity loan in a previous blog post.
About Janet Weinhofer
Jan is the VP of Lending at GOLD. She directs and coordinates all lending activities within the credit union, ensuring compliance with lending policies. She ensures her team provides friendly, professional, timely, and personal service to all our Members. Jan is proud to be part of GOLD’s mission to empower our Members to achieve personal financial success.
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