A home equity line of credit, or HELOC, has long been a popular way to leverage your home equity and get your hands on a quick injection of cash. In the past, one of the great advantages of using a HELOC, rather than an unsecured loan or credit card, was that you could deduct the interest you paid up to $ 100. $ 000 of the balance.
But under the new Tax Cuts and Jobs Act of 2017, the rules have changed. And if you’re not clear on how the new law affects you, you could make mistakes with your HELOC that could cost you dearly! Once these mistakes are made, it can be difficult, if not impossible, to undo them. It is therefore crucial that you are clear about what you can (and cannot) do with a HELOC today.
To help you out, here are some common mistakes people make with HELOCs so you know what not to do, at tax time or anytime.
1. Not understanding the new HELOC rules
If you opened your account before January 1, 2018, you could purchase a HELOC and spend the money on anything. Whether you spend this money to fund a child’s school fees or to pay the bill for a wedding or even a new boat, you could deduct the interest on this loan as an expense in your itemized tax deductions, just like you deduct the interest on your mortgage.
The Tax Cuts and Jobs Act of 2017 changed all that. Now you can only deduct interest to the extent that your HELOC balance is used to buy, build, or significantly improve the house that secures that debt. This applies to all HELOCs; it doesn’t matter when you took out your HELOC or when you spent the money; there is no grandfathering provision.
Now, if you are filing your income tax returns and have a deduction for HELOC interest charges, you need to show proof of what you want to deduct, depending on Ralph DiBugnara, president of HomeQualified in New York.
If you can’t prove that this interest was paid on a loan used to buy, build, or improve your home, the IRS could deny your deduction and you could potentially face taxes and penalties.
2. Using bad funds to pay for home renovations
As tempting as it can be to try and get credit card rewards and a tax deduction on interest, don’t rely on using your non-HELOC credit cards and cash to pay for home renovations and then your HELOC to pay off the balance.
Although no specific IRS guidance has been issued on this point, “I would err on the side of caution,” says Kevin Michels, a financial planner in Draper, UT. “Taking out a $ 10,000 HELOC to pay off a credit card you used to do a home renovation technically does not use the proceeds from your HELOC to do a home renovation. He uses the proceeds to pay off a credit card.
To be safe, spend your HELOC funds directly on qualifying expenses.
3. Not knowing what is considered a “substantial” home improvement
If you are trying to use your HELOC for qualifying purposes or if you are trying to track the percentage of your HELOC balance that is considered a home improvement expense, make sure you know what types of expenses you can use. To be eligible, the improvements must increase the value of your home.
“For example, repairs that just keep the house in good condition, like painting, don’t count,” says Michels. “Money has to be spent on improvements that increase value, such as renovating a kitchen, building an addition, or building a patio. “
But in some cases repair and maintenance of projects can be interpreted as material improvements. For example, painting is normally part of maintenance and repair and is not eligible. However, if you add a room to your home, you can count all the expenses associated with adding the room, including painting.
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4. Use of your HELOC funds for mixed purposes
Technically, you can use a portion of your HELOC funds for vacations, restaurant meals, and general household expenses, and a portion for major home improvements, while deducting interest on the portion devoted to home improvements.
“If you take out a loan of $ 50,000 and spend half of it on renovating your kitchen and the other half on paying off your debts, you can still deduct 50% of the interest,” says Michels.
However, mixing funds for different purposes is rarely a good idea. It can get messy. What if you made purchases and payments from a HELOC account for qualifying and non-qualifying purchases over a period of multiple years? Let’s talk complicated!
Since the new tax law for HELOCs does not contain grandfathering provisions, there is no doubt that many taxpayers will be trying to determine what percentage of their HELOC balance is eligible over the next several years. For previous purchases, you will have to do your best. Keep records and documents, in case you are audited and need to show how you arrived at the percentage of your HELOC balance eligible for the interest deduction.
Going forward, however, you will save yourself a lot of trouble if you use your HELOC fund one end at a time, whenever possible.
5. Deduct interest when the HELOC is not guaranteed by the same house you spent the money on
According to the IRS, to qualify for the deduction, you must not only spend the money to buy, build, or significantly improve your home, but the HELOC must be secured by that home. If the HELOC is secured by other real estate, the interest on your HELOC is not deductible.
6. Interest deduction on loans in excess of IRS limits
Even if you use HELOC funds for eligibility purposes, the amount of debt on which you can deduct interest may be subject to one of these limits:
- $ 100,000 home equity loan or line of credit limit: You can only deduct interest on a maximum of $ 100,000 of home equity debt. If your home equity line of credit is over $ 100,000, you can only deduct interest on $ 100,000 of that debt.
- Limit of $ 750,000 on total mortgage debt: Generally, you can only deduct interest on the first $ 750,000 of your mortgage debt, including first mortgages and mortgages. The limit is higher – $ 1 million – if you obtained qualifying mortgage debt and HELOCs before December 15, 2017.
- Total debt limit based on the purchase price of the house: In addition to the above limits, you can only deduct interest on your total mortgage debt. This includes your first mortgage and any HELOCs, up to the total amount you paid for your home. So if you paid $ 250,000 for your house and purchased a HELOC for $ 25,000, you can only deduct interest up to a maximum of $ 275,000.
7. Do not take the deductions to which you are entitled
As HELOCs have gotten more complicated, you might think it’s best not to deduct any interest on this loan at all. But being afraid to take legitimate deductions is a costly and unnecessary mistake. If you’ve used your HELOC for qualifying expenses to buy, build, or significantly improve your home, these deductions are worth making, so keep your receipts and records. Do not miss!
8. Consider only the tax aspects of having a HELOC
Even if you can’t deduct the interest, getting a HELOC can still be a cost effective way to borrow money.
“The average rate is around 4%, so it’s still a cheaper way to borrow than a credit card would be,” says DiBugnara. “The closing costs are very low, they are quick to close, and they offer an interest-only payment option. “
Plus, with a home equity line of credit, you only pay interest on your outstanding balance. You can pay it back when you have extra cash, knowing that you can withdraw cash when you need it.
“As long as you make that money work for you, for example by investing in other properties, and your rate of return is higher than the cost of your HELOC, it’s a good tool,” says DiBugnara. “I think if you are purchasing a HELOC for other purposes, you should be aware that you are not getting tax relief, but are using the HELOC for the purpose you got it for.”