The IRS recently issued Notice 2018-32, which advises taxpayers on the ability to deduct interest on home equity loans (collectively, a “HELOC”) following the 2017 Tax Act. This is a timely response to the questions that arose concerning this issue following the Act’s passage.
New Code Section 163(h)(3)(F)(i)(I) suspends the deductibility of interest on home equity debt of a “qualified residence” for tax years beginning in 2018 through 2025. During that period, only home mortgage interest on “acquisition indebtedness” may be deducted. Acquisition indebtedness is defined in Code Section 163(h)(3)(B) as debt that is (i) incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer and (ii) secured by such residence. Home equity indebtedness specifically excludes acquisition indebtedness pursuant to Code Section 163(h)(3)(C)(1). Notice 2018-32 clarifies that if the home equity loan, line of credit or second mortgage qualifies as acquisition indebtedness, then the suspension of interest deductions on a HELOC under the 2017 Tax Act would not be applicable, and the interest would be deductible. In reality, in that case, the debt would not be classified as home equity indebtedness, despite the specific terminology used in the loan.
A qualified residence is defined in Code Section 163(h)(4) as the principal residence of the taxpayer and one additional residence. Accordingly, one vacation home can also count as a principal residence, as long as the taxpayer does not treat the vacation property as a trade or business (i.e. by renting it out).
Notice 2018-32 clarifies via example that the HELOC must secure the applicable qualified residence in order to be treated as a qualified indebtedness. If a taxpayer secures a HELOC by its primary residence to acquire, construct or improve a vacation home, then the deduction for the interest expense on the HELOC would be suspended as the debt would not be “acquisition indebtedness” since the debt would be secured by the primary residence but used to improve the vacation home. If the taxpayer secures an HELOC by a vacation home to acquire, construct or improve the vacation home, then the HELOC would be classified as acquisition indebtedness and the interest expense would be deductible (subject to overall deductibility limitations, as discussed below). Similarly, if a taxpayer secures an HELOC by a primary residence to acquire, construct or improve the primary residence, then the HELOC would be classified as acquisition indebtedness and the interest expense would be deductible (subject to the overall deductibility limitations).
Under the new Tax Act, the maximum amount of acquisition indebtedness has been reduced to $750,000 for married filing jointly (and $375,000 for married filing separately). The prior limit of $1,000,000 ($500,000 if married filing separately) continues to apply if the taxpayer had a binding contract by December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, so long as the closing occurs before April 1, 2018.
