There’s nothing like tax reform to create confusion among taxpayers. Previously, we wrote that home equity loans in New Jersey (and nationwide) would no longer be tax-deductible, thanks to the new legislation signed into law on December 22. Most major news sources were reporting the same.

As it turns out, there’s more to this story. The Internal Revenue Service recently published a news release to clarify this issue and to eliminate some of the confusion. (It seems that even the CPAs were scratching their heads over this one.)

What you need to know: The interest paid on home equity loans in New Jersey could still be tax-deductible, if the funds are used to “buy, build or substantially improve” the property used to secure the loan.

Interest on Home Equity Loans Deductible in Some Cases

On February 21, 2018, the IRS issued a special advisory to explain that, in many cases, taxpayers can continue to deduct interest paid on home equity loans. The fact that they even issued this advisory indicates the widespread confusion over the subject. In fact, they mentioned it directly:

“Responding to many questions received from taxpayers and tax professionals, the IRS said that despite newly-enacted restrictions on home mortgages, taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC) or second mortgage, regardless of how the loan is labelled.”

• Basically, if you’re using the money received to build out or improve the property, the interest you pay on the equity loan should be tax-deductible.
• But if you’re using the money for other expenses (like college tuition, a vacation, or paying off credit card debt), the tax deduction is no longer allowed.

Mortgage-Related Deductions Capped at $750,000

Also keep in mind that the Tax Cuts and Jobs Act lowered the total dollar limit for mortgage interest deductions. This change could affect quite a few homeowners in New Jersey, given the relatively high cost of homes in some parts of the state.

As the IRS statement explains:

“Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The limit is $375,000 for a married taxpayer filing a separate return. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.”

Their advisory also provided some example scenarios to show how mortgage interest might be deducted, up to the limit of $750,000. Here is one such scenario:

A home buyer in New Jersey uses a $500,000 mortgage loan to buy a house that’s valued at $800,000. Later, the new homeowner takes out a home equity loan in the amount of $250,000 to put an addition onto the main home. In this scenario, both of the loans (primary mortgage and equity loan) are secured by the main home and the total does not exceed the market value of the house. Because the combined total of the loans does not exceed $750,000, all of the interest paid is tax deductible.

This scenario meets the key requirement for the tax deduction on home equity loan interest. That’s because the funds received were used to either “buy, build or substantially improve” the property  being used as collateral. This appears to be the key stipulation that determines whether or not the interest is deductible.