HELOCs and Home Equity Loans: The tax deduction may be curtailed. What does this mean for homeowners?

On January 1, 2018, a new tax reform law became effective. It will affect the ability of many homeowners to deduct mortgage debt interest on their future tax returns.

HELOC vs. Home Equity Loan
A HELOC, or a home equity line of credit, is similar to a credit card with an adjustable rate and a fixed loan limit. A HELOC allows you to borrow or re-borrow from time to time. HELOCs are an attractive method of providing money to make improvements to the home, buy a car, pay off debt, etc. In contrast to a HELOC, a home equity loan is a one time loan that usually has a fixed rate of interest and provides a one time loan amount in full at closing.

What does the new tax legislation say?
Before the new tax reform law, homeowners were able to deduct the interest from a home equity loan or HELOC up to $100,000. The new law eliminates that safe haven after 2018. Interest on HELOCs and home equity loans may still be deductible to homeowners who qualify under the new criteria.

The new law states that the deductibility of the mortgage loan will depend upon two criteria. The first criteria deals with total mortgage indebtedness. The new law states that any mortgage debt that was acquired on or after December 15, 2017, has a new cap of $750,000 for interest deductions. If it was acquired before December 15, 2017, then the old $1,000,000 limit will remain for those homes. If homeowners already have a $750,000 mortgage, then they will not be able to deduct interest from a new additional loan.

The second criteria for mortgage interest deductibility under the new law involves the purpose of the loan.  If the loan was to acquire the residence or for home improvement (called “acquisition indebtedness”) then the interest is deductible.  To the extent that the loan proceeds were used for any other purpose (called “home equity indebtedness”), then the related interest is not deductible.  Loan interest may have to be split between deductible and non-deductible.

Under the new tax law, for example, if you have an $80,000 HELOC, a $50,000 portion of which was used to improve the property, and the rest used to pay down other loans, then the interest is split; five eighths of it is tax deductible ($50,000/$80,000).

So, what do we do now?
Because the new tax law limits the interest deductibility on HELOCs and home equity loans, people may want to consider alternatives to obtain funds. One example is a refinance. This involves replacing an existing loan or loans with a new loan, perhaps at a lower interest rate. Another example is a cash out refinance. This involves a refinance of a mortgage for more than what is currently owed and the difference is received as cash. These options may afford a better interest rate and/or better tax deductibility.

The bottom line is to consider your needs and finances, along with the new criteria, before acquiring a HELOC or home equity loan in the future.