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Is Home Equity Loan Interest Tax Deductible?

Under what circumstances can you get a home equity loan tax deduction?

Now that New Year festivities have come and gone, it’s time to start thinking about another annual milestone: tax season. April 15 may be several months away, but it can appear to pop up quickly if you’re not prepared.

One big question homeowners are asking this year is whether interest on a home equity loan is still tax deductible under the new tax law. The answer is yes, but there are more limitations than in previous years.

The Tax Cut and Jobs Act was passed in 2017, but this is the first year homeowners will be applying the new rules to pay their taxes. Under the new law, you can deduct mortgage-related interest on up to $750,000 worth of qualified loans for married couples filing jointly and $375,000 for separate filers for any home purchased after Dec. 15, 2017. The changes under the new law apply to all tax years between 2018 and 2025.

The deduction amount includes the interest you pay on your mortgage, home equity loan, home equity line of credit (HELOC) or mortgage refinance. If you took on the debt before Dec. 15, 2017, you can deduct interest on $1 million worth of qualified loans for married couples and $500,000 for those filing separately for the 2018 tax year.

Here’s another change homeowners need to know: Under the new law, you’ll only be able to deduct interest on loans used to purchase, build or substantially renovate your home. In the past, you could deduct interest even if you used your HELOC or home equity loan for non-property-related expenses, such as buying other assets or consolidating debt. Now the deduction applies exclusively to expenses related to the house.

When it comes to deducting interest for home renovation loans, homeowners will need to be on guard, too. For one, the IRS has only defined a “substantial” improvement to a home as one that adds value, prolongs its useful life or adapts a home to new use. This means homeowners who put on an addition, overhaul key structural elements or make the home more livable or accessible are likely to qualify. But those who make cosmetic upgrades may not. In a publication issued at the end of 2018, the IRS wrote that “repairs that maintain your home in good condition, such as repainting your home, aren’t substantial improvements.”

Should I deduct interest on my home equity loan?

This will depend on a few factors. Under the new tax law, the amount that qualifies as a standard deduction has increased. Single filers can now claim a $12,000 standard deduction, while married people filing jointly, married people filing separately and heads of households can claim $24,000, $12,000 and $18,000, respectively. Filers who are elderly or blind may claim additional standard deductions; the amount depends on their marital status.

You may find that the standard deduction for which you’re eligible gives you more of a tax break than itemizing home equity interest and other eligible expenses. Or you might find your itemized deductions are actually larger.

Changes to the alternative minimum tax (AMT) exemptions may influence your choice, too. The AMT applies to high-income taxpayers to ensure they pay a minimum amount of taxes, rather than using loopholes and credits to avoid paying. Taxpayers subject to the AMT must calculate both a regular return and an AMT return and pay on whichever amount is higher.

Under the new tax law, fewer people will pay the AMT than in the past. For married taxpayers who file jointly, the exemption will now start at $109,400; it will begin at $54,700 for those married but filing separately and $70,300 for all other filers. Before the new law, the exemption started at $84,500 for married couples who filed jointly, $42,250 for married couples who filed separately and $54,300 for those who filed as individuals.

If you are obligated to pay the AMT, you can deduct mortgage interest as an itemized expense but not home equity interest, says Marguerita Cheng, a certified financial planner and the chief executive officer of Blue Ocean Global Wealth in Gaithersburg, Md. The take-home: If you’re a high-income taxpayer, itemizing home equity interest payments may offer fewer benefits.

Rules on deducting home equity loan, HELOC or second mortgage interest

Still trying to decide what to do? If so, follow the guide below:

What you can deduct: If you bought your home after Dec. 15, 2017, you can deduct interest on loans up to $750,000 if you’re married and filing jointly and $375,000 if you are filing separately. Homeowners who purchased eligible properties before Dec. 15, 2017 may deduct interest based on the previous limits: Those who are married filing jointly may claim on loans up to $1 million; those filing separately can deduct interest paid on up to $500,000 of qualifying loans.

To determine the total amount of interest you might be able to deduct, combine the loan amounts of your primary mortgage, home equity loan, HELOC or second mortgage and make sure it doesn’t exceed one of the maximums above. If the total is larger than the applicable limits, you’ll only be able to deduct a portion of the paid interest.

Which loans qualify: You can only deduct mortgage-related interest on your primary residence and second home. Eligible loans must be secured by either your primary or secondary residence.

What the money has to be spent on: In order to deduct home equity interest, you must have used the loan or line of credit on substantial renovations. Also, even if you took out a HELOC, home equity loan or a second mortgage before 2018, you’re still subject to the new qualification rules. In other words, if you used the money to pay for medical expenses or your child’s school tuition and previously deducted the interest on it, you will not be able to deduct it again this year.

If your took out a HELOC and used a portion of it on expenses that qualify (such as a renovation), you may want to talk with a tax adviser as this is more complicated than a straightforward deduction.

What doesn’t qualify: Again, if you spent home equity proceeds on anything other than renovations, the interest will not qualify for the deduction. Remember, only interest paid on loans for your primary and second residences may be deducted.

How to prove what the money was spent on: Keep all receipts and invoices for renovation labor and materials organized and secure. You’ll need them if you get audited, as they’ll help prove your deductions were valid.

What you’ll need to deduct home equity interest

Keep an eye out for your 1098 forms, which you should receive by Jan. 31. These will come from your mortgage and home equity lenders, and they’ll show the interest you paid during 2018. If you have loans that are near the allowed limits or used portions of the loans for non-qualifying expenses, you may need to use the IRS’ Publication 936 to calculate exactly how much interest you can deduct.

Other tax breaks for homeowners

Mortgage interest

You may deduct the interest on loans used to purchase your house, as well as refinanced mortgages. With the latter, you can deduct interest up to the home’s purchase price.

Points

If you choose to itemize your deductions, you may be able to deduct the points you paid on your mortgage to lower your long-term interest rate. You can opt to deduct points the year you buy the house or throughout the life of the loan.

Property tax

As with point deductions, you’ll have to itemize to get a tax break with property taxes. But if you do, you can deduct up to $10,000 paid on state and local property taxes.

If that doesn’t sound like much now, it isn’t. In a huge, sweeping change from previous tax law, the Tax Cuts and Jobs Act of 2017 restricts all itemized deductions of state, local and property taxes to just $10,000 for married couples filing jointly ($5,000 for those filing separately). Before, taxpayers were able to deduct 100% of these taxes. Tax experts expect the change to be felt most in states like New York and California, where property taxes are especially high.

Capital gains

When you sell a personal home, you’re eligible to keep a portion of the profits tax-free under capital gains tax laws. Married couples can keep up to $500,000 of their sale-related gains tax-free; for individual filers, the number is $250,000.

What to expect for the 2019 tax year

By the time you file your 2019 taxes, standard deduction amounts will have risen slightly; for example, the deduction for married couples filing separately will be $24,400 and $12,200 for single taxpayers and married individuals filing separately. Meanwhile, the AMT exemption for individuals will be $71,700 and start to phase out at $510,300. For married couples who elect to file jointly, the exemption will start at $111,700 and phase out will begin at $1,020,600.

Taxpayers can expect to see other changes to their taxes, too. For instance, the maximum allowed credit for adoption expenses will increase from $13,810 to $14,080. Taxpayers who aren’t enrolled in health insurance coverage will not have to pay a penalty in 2019, though the penalty for 2018 is $695.

Consider hiring a professional

If you usually prepare your taxes yourself, this might be the year to hire a professional — especially if you’re not sure about deduction eligibility or whether you should itemize or just take the standard deduction.

Dennis Nolte, a certified financial planner and vice president at Seacoast Investment Services in Winter Park, Fl., notes that hiring an experienced tax preparer absolves you of some of the responsibility with possible filing errors and also gives you a chance to better understand your obligations.

“If you’re at all confused or pulling your hair out two days before April 15, there’s no reason for you to do that,” Nolte said. “Just go get somebody and learn from them, and then maybe next year, you don’t have to do this again.”

 

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