The fact that equity debt will no longer be deductible in 2018 through 2025 has triggered numerous questions and discussions about allocating home equity debt interest. This has been an area of frequent abuse in the past. The following are a set of rules that must be applied when dealing with home equity debt.
1. If the equity debt is secured by the home, then the first $100,000 MUST be treated as home equity debt, and in years when deducting equity debt isn’t barred, the interest on the $100,000 MUST be deducted on Schedule A as home equity interest; it cannot be allocated. If the equity debt is greater than $100,000, then interest on the debt in excess of $100,000 can be allocated to the use of the funds.
2. The taxpayer can make a written election (irrevocable without IRS permission) to treat a debt secured by the home as “unsecured.” Home mortgage debt by definition must be secured by the home for any of the interest paid on it to be deductible. Thus, if a loan is unsecured no portion of the interest on the loan can be allocated as home mortgage interest and the debt becomes what the IRS refers to as excess debt. The excess debt can be traced (Reg. Sec. 1.163-8T) to its actual use (but not back to the residence since it is no longer considered to be secured by the home). Interest paid on the traced excess debt may or may not be deductible depending on what the debt was used for. If not used for a deductible purpose, then it is not deductible at all.
3. Where a home equity loan is taken out to pay for higher education it can be treated as an education loan if the “unsecured” election is made and the loan is only used for education. Education loans by definition must be single purpose loans. Thus interest for a loan used for education expenses and other purposes cannot be partially allocated as education interest.
4. Home equity debt is not deductible for AMT purposes and can certainly cause or add to a taxpayer’s AMT tax.
5. For 2018 through 2025, the deduction of home equity debt interest is suspended. Does the fact that the equity debt interest deduction is suspended mean you can trace all of a home’s non-acquisition debt interest to education, Schedule E, Schedule C or to an investment? Or will only the interest on equity debt in excess of $100,000 be traceable? We have to wait until the IRS provides guidance. However, since the deduction is only suspended, the debt would seem to retain its character as home equity debt and the unsecured election would have to be made to be able to trace the debt to other uses.