The Tax Cuts and Jobs Act (“TCJA”) further restricted the deduction of interest expense incurred by taxpayers to acquire or improve their principal home and/or a second home. Prior to the TCJA, taxpayers were permitted to deduct interest expense on up to $1 million of debt used to acquire or improve a principal residence and secured by the residence. Taxpayers were also allowed to deduct interest expense on up to $100,000 of home equity debt. The home equity debt had to be secured by the principal and/or second residence; however, the proceeds of such debt could be used for any purpose.
Under the TCJA, two significant changes were made. First, interest on home equity debt is not deductible for tax years 2018 through 2025. Second, the limitation on acquisition debt was reduced from $1 million to $750,000 for taxable years 2018 through 2025. For acquisition debt that was incurred prior to December 15, 2017, interest will remain deductible on up to $1 million of such debt. There is also a binding contract exception that allows the $1 million limit to apply if the taxpayer had a binding written contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and the taxpayer actually purchased the residence before April 1, 2018. Indebtedness that qualifies for the $1 million limitation may be refinanced after December 15, 2017; as long as the principal amount of the debt is not increased, the interest will remain deductible on $1 million of such debt.
The Internal Revenue Service (“IRS”) recently issued IR 2018-32 to remind taxpayers that certain debt commonly thought of as home equity debt may still give rise to deductible interest. The IRS gave several examples. If a taxpayer borrows $500,000 to purchase his principal residence, he could later borrow up to an additional $250,000 in order to expand or improve that residence and still deduct all of the interest. Alternatively, if a taxpayer borrows $500,000 to purchase his principal residence, he can borrow up to $250,000 to purchase a second home and still deduct all of the interest.