Navigating the Future of Home Equity Loan Deductibility: IRS Guidelines and Record-Keeping Best Practices

The recent changes to tax laws introduced by the TCJA have led to significant shifts in how home equity loans are treated for the purposes of tax deductions. Understanding these changes and how to navigate them is crucial for both homeowners and financial advisors.

IRS Guidelines on Home Equity Loan Deductibility

Under the TCJA, the deduction for interest paid on home equity loans and lines of credit (HELOCs) is suspended from 2018 to 2026, provided that the funds are not used to purchase, build, or substantially improve the taxpayer's primary residence. However, the IRS has emphasized that the use of the funds is crucial in determining deductibility.

For instance, if a portion of the HELOC funds is used for home improvements, and the other part for ineligible purposes, the IRS has not provided explicit guidelines on how to separate the taxable and tax-exempt parts of the loan. This uncertainty highlights the importance of thorough record-keeping.

Proving Deductibility of Home Equity Loan Usage

According to the IRS, taxpayers must demonstrate the purpose for which the money from a home equity loan was used. This can be challenging, especially if the funds were borrowed over an extended period and used for various purposes. Forbes suggests that keeping detailed records, including invoices, spending reports, and any supporting documentation, is essential.

Typically, tax records need to be maintained for three to seven years. However, for HELOCs, homeowners may need to retain records for a much longer period, depending on their intent to claim deductions on the interest paid.

Scenario-Based Analysis

Consider a scenario where a homeowner borrows a total of $100,000 via a HELOC. Out of this amount, $60,000 is used for home improvements, and $40,000 is used for other purposes, such as consolidating debt. In this case, only the $60,000 portion is eligible for a deduction on the interest paid.

Let's explore a more complex scenario: if $25,000 of the originally eligible $40,000 is repaid, and then $15,000 more is borrowed for an eligible expense, the remaining $15,000 of the original $40,000 might still be eligible for a deduction. Although there is no official guidance on this matter, it is advisable to maintain all related records.

Homeowners should anticipate the possibility of a first-in, first-out (FIFO) approach, where the interest on the original eligible amount is deductible until fully repaid. Any additional borrowing for eligible purposes would then be subject to deduction.

Future Clarity and Additional Changes

The IRS is expected to provide additional guidance, possibly through a new form or instructions with worksheets. Until such guidance is available, it is crucial for homeowners to adhere to the current guidelines and maintain thorough documentation.

Additional Impacts of the TCJA

The TCJA has not only affected home equity loans but also a range of other deductions. For example, the deductions for state and local (SALT) taxes, mortgage interest, charitable contributions, and other miscellaneous itemized deductions have been suspended. Certain miscellaneous itemized deductions, such as unreimbursed work expenses and investment fees, must now exceed 2% of adjusted gross income (AGI) to be deductible.

Conclusion

The future of home equity loan deductibility remains somewhat uncertain, with the IRS still working on providing clear guidance. Homeowners should focus on maintaining detailed records and staying up-to-date with any new developments in tax law. This proactive approach will help them navigate the complexities of these changes and make informed decisions regarding their financial and tax planning.