Homeowners with home equity loans may be reaping the benefits of deducting interest paid in 2017, but they shouldn’t get used to it.
The new tax reform law drastically changed how the tax code will treat home equity debt — but few consumers understand how that change will affect their tax bill.
Only 4.4% of borrowers correctly identified that the new tax code will hurt home-equity loan borrowers because it eliminated this deduction in a recent poll of 1,000 borrowers. And more than half of the borrowers surveyed (54%) either thought that the new tax code positively affected the treatment of home equity loans or that didn’t impact it at all.
“There were so many proposals to eliminate or reduce certain deductions, so there was a lot of confusion right until the end,” said Sandra Block, senior editor at personal-finance publication Kiplinger.
How the tax code will now treat home equity debt
Before the GOP tax reform package became law, homeowners could deduct the interest paid on up to $100,000 in home equity loans or home equity lines of credit. The Internal Revenue Service recently clarified that borrowers can still deduct this interest. But there’s a big catch: The funds from the home equity loan must be put toward a home improvement project or renovation.
And even for those who can still make use of this deduction there are limits. Borrowers can now only deduct the interest on up to $750,000 in housing-related debt. So if a borrower’s first mortgage and their home equity line of credit add up to less than $750,000, they’ll be fine. For those whose status is married filing separately, the limit is $375,000.
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But if someone’s outstanding debt on their primary mortgage exceeds $750,000, then they won’t be able to deduct the interest on their home equity loan or line of credit — even if it’s used for a home improvement or renovation project, Block said. These changes won’t apply to the current tax season, but will be in effect next year.
Many borrowers are affected by this change. A study released by TransUnion TRU, -0.91% in October predicted that 10 million consumers will open a home equity line of credit between 2018 and 2022 — more than double the number of consumers who did so from 2012 to 2016. As of the third quarter of 2017, the balances on home equity lines of credit totaled $448 billion, according to data from the Federal Reserve Bank of New York.
Some 62% of Americans with home equity lines of credit opened one to pay for home improvements and repairs, a recent survey from personal-finance website NerdWallet found. Other common uses for funds tapped through a home equity loan include paying off other forms of debt or for major expenditures such as buying a new car or paying for a child’s college tuition.
Moreover, 27% of these borrowers get a home equity loan and don’t use it right away, saving it for a rainy day. With the changes made to the tax code, these borrowers will no longer be able to deduct the interest they paid on these loans if the funds are used in this way. But that doesn’t make it a bad strategy, Block said. “It’s still a good idea to have one because it’s a really good source of emergency funds,” she said. “It’s still going to be a lower rate than credit cards or personal loans.”
Borrowers should compare home equity loans with other loan options, including personal loans, to ensure they get the best rate possible if they can’t deduct the interest paid.
How to prepare for tax season next year
It’s still unclear precisely how the IRS will have borrowers document how they used the money they tapped through a home equity line of credit. Regardless of how the process will actually work, borrowers need to make sure they keep thorough records of how much they spend and on what.
“They need to keep statements,” said Steven Hamilton, an accountant based in Grayslake, Ill. “If they have a debit card connected to that home equity line of credit they need to keep every statement.”
Those documents will come in handy if a borrower is ever audited. And borrowers should keep these documents for as long as they have the loan or line of credit open.
Because this documentation will be so important though, they need to ensure they hire workers or contractors who can provide proof of payment. In other words, hiring day laborers and paying them off the books could disqualify a borrower from being able to deduct their interest payments.