Interest on home equity loans is still deductible, but with a big caveat

The interest paid on that home equity loan may still be tax deductible, in some cases.

Many taxpayers had feared that the new tax law — the Tax Cuts and Jobs Act of 2017, enacted in December — was the death knell for deducting interest from home equity loans and lines of credit. The loans are based on the equity in your home and are secured by the property. (Home equity is the difference between what the house is worth and what you owe on your mortgage.)

But the Internal Revenue Service, saying it was responding to "many questions received from taxpayers and tax professionals," recently issued an advisory. According to the advisory, the new tax law suspends the deduction for home equity interest from 2018 to 2026 — unless the loan is used to "buy, build or substantially improve" the home that secures the loan.

If you take out the loan to pay for things like an addition, a new roof or a kitchen renovation, you can still deduct the interest.

But if you use the money to pay off credit card debt or student loans — or take a vacation — the interest is no longer deductible.

(As was already the case, the IRS said, the loan must be secured by your main home or a second home, and must not exceed the cost of the home, to be eligible for the interest deduction.)

The IRS also noted that the new law sets a lower dollar limit on mortgages overall that qualify for the interest deduction. Beginning this year, taxpayers may deduct interest on just $750,000 in home loans. The limit applies to the combined total of loans used to buy, build or improve the taxpayer's main home and second home.

Say that in January 2018, a taxpayer took out a $500,000 mortgage to buy a home valued at $800,000. Then, the next month, the taxpayer took out a $250,000 home equity loan to build an addition on the home. "Because the total amount of both loans does not exceed $750,000," the IRS said, "all of the interest paid on the loans is deductible." But if the taxpayer used the loan for "personal" expenses, like paying off student loans or credit cards, the interest would not be deductible.

Often, homeowners borrow against their home equity because the interest rates are typically lower than other types of credit. A home-equity loan works like a traditional second mortgage: It's borrowed at a fixed rate for a specific period. A home equity line of credit is more complex: Borrowers can draw on it as needed over an initial draw period — typically 10 years — during which interest rates fluctuate. After that, the balance typically converts to a fixed-rate loan.

A recent survey done for TD Bank, an active home equity lender, found that renovations are the top use for home equity lines of credit (32 percent), followed by emergency funds (14 percent) and education expenses (12 percent).