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Tax law alters approach to home equity interest

This column continues a series of discussions about the new tax law. Today I’ll address the home equity interest deduction and how to deal with the changes to the law.

Through the end of 2017 a homeowner could deduct interest on “acquisition” debt up to $1 million of principal, and could also deduct interest on “home equity debt” up to a principal balance of $100,000.

These terms are defined by the law and the definitions can be important in determining the allowed deduction, particularly in 2018 and future years.

Acquisition debt is debt incurred to acquire, construct, or improve a principal residence or one other residence selected by the taxpayer. The debt must be secured by the residence.

Home equity debt is also secured by the residence but is not acquisition debt. It includes debt used for purposes other than acquisition, construction, or improvement, or acquisition debt in excess of $1 million.

Through the end of 2017, interest on home equity debt is deductible for regular tax purposes without regard to how the proceeds are used. The interest is deductible for alternative minimum tax only if the debt is used to acquire, construct, or improve the residence.

Beginning in 2018, the law changes in two ways. First, acquisition debt is limited to $750,000 of principal. Existing debt incurred on or before December 15, 2017, is “grandfathered” up to the current $1 million limit.

Home equity debt interest is no longer deductible. This is so even for debt incurred before the law change. Many people with home equity loans will be surprised to learn that the rules changed after they had incurred the debt.

Let’s now discuss what a taxpayer with an existing home equity loan may do to try to salvage the tax deduction for interest paid.

The 1986 Tax Reform Act changed the deductibility of interest, including a prohibition on deducting personal interest. Business interest is still deductible and investment interest can offset investment income.

When money is borrowed, the law requires that the debt proceeds be traced to specific uses to determine how to classify the interest. If proceeds are traced to a business, the interest becomes business interest, and so on.

Home acquisition debt and home equity debt continued to be deductible even if the proceeds are for personal purposes. To make it easier to secure a deduction the law creates a presumption in favor of deductible residence interest.

A loan secured by a residence is presumed to be used for a deductible (residence) use. This is a good result, since both acquisition debt and home equity debt generally produce a deduction.

To avoid classification as residence interest, a taxpayer must elect to treat the loan as if it is not secured by the residence. This election may be made in any year, but once made, it is binding for all future years.

So let’s say someone borrowed $50,000 in 2016 and used the proceeds to purchase an investment. The loan is secured by the taxpayer’s principal residence and the bank calls it a home equity loan.

What the bank calls the loan does not matter in the eyes of the tax law. Because the loan is secured by a residence, the loan is home equity debt and the interest is deductible in 2016 and 2017. This is the presumed treatment.

Because no deduction is allowed for interest on home equity debt in 2018, the taxpayer should reclassify the debt as investment debt based on how the proceeds were used.

To do this, an election will need to be made on the 2018 return to treat the debt as if it were not secured by the residence. It then no longer qualifies as residence (home equity) debt and must be classified based on how the loan proceeds were used.

Since the proceeds were used for purchase of an investment, the interest for 2018 and future years is classified as investment interest. It can then offset investment income.

The taxpayer must itemize deductions, but they also would need to itemize to deduct home equity interest through the end of 2017. So the strategy places them in the same position as they were in before 2018.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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