Monday, March 16, 2020

If You Must, Avoid Mistakes Using a HELOC

A home equity line of credit, or HELOC, has long been a popular way to tap the equity in your home and get your hands on a quick infusion of cash. In the past, one big plus of using a HELOC—rather than an unsecured loan or credit card—was that you could deduct the interest you paid on 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 some mistakes with your HELOC that could cost you big-time! Once you make these errors, it can be difficult or impossible to undo them. So, it's crucial that you're clear on what you can (and can't) do with a HELOC today.

1. Not understanding the new HELOC rules

If you opened your account before Jan. 1, 2018, you could take out a HELOC and spend the money on anything. Whether you spent this cash to fund a child's college tuition or foot 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 regular mortgage.

The 2017 Tax Cuts and Jobs Act changed all that. Now, you can deduct the interest only to the extent that the balance on your HELOC is used to buy, build, or substantially improve the home that secures this 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 provision grandfathered in.

Now, if you file your tax returns and take a deduction for HELOC interest expenses, you need to show proof of what you want to write off, according to Ralph DiBugnara, president of HomeQualified in New York City.

If you can't prove that this interest was paid on a loan used to buy, build, or improve your home, the IRS could disallow your deduction—and you could potentially face back taxes and penalties.
2. Using the wrong funds to pay for home improvements
As tempting as it may be to try to get credit card rewards and a tax deduction on the interest, don't count on using your non-HELOC credit cards and cash to pay for home improvements, and then using your HELOC to pay off the balance.

While no specific IRS guidelines have 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 make a home improvement technically isn't using your HELOC proceeds to make a home improvement. It's using the proceeds to pay off a credit card."

To be safe, spend your HELOC funds directly on qualifying expenses.
3. Not knowing what qualifies as a 'substantial' home improvement
If you're trying to use your HELOC for qualifying purposes, or trying to track the percentage of your HELOC balance that qualifies as home improvement expense, make sure you know what kinds of expenses you can use. To qualify, the improvements must increase the value of your home.

"For example, repairs that simply maintain the home in good condition, like painting, do not count," says Michels. "The money must be spent on improvements that increase the value, like remodeling a kitchen, building an addition, or constructing a deck."

But in some cases, fixing and maintaining projects can be construed as material improvements. For example, normally paint is part of maintenance and repair and does not qualify. However, if you add a room to your house, you can count all the expenses of adding the room, including the paint.
4. Using your HELOC funds for mixed purposes
Technically, you can use some of your HELOC funds for vacations, eating out, and general household spending, and some of it for major home improvements, and still deduct the interest on the portion that is for the home improvements.

"If you take out a $50,000 loan and spend half of it on remodeling your kitchen and the other half to pay off debt, you can still deduct 50% of the interest," says Michels.

Co-mingling funds for different purposes is seldom a good idea, however. It can get messy. What if you've made purchases and payments from a HELOC account for qualifying and nonqualifying purchases over a period of years? Talk about complicated!

Because the new tax law for HELOCs does not have provisions grandfathered in, there's no doubt many taxpayers will find themselves trying to determine what percentage of their HELOC balance qualifies in the next several years. For previous purchases, you'll have to do the best you can. Save records and documents, in case you are ever audited and need to show how you arrived at the percentage of your HELOC balance that qualifies for the interest deduction.

Going forward, however, you'll save yourself a lot of trouble if you use your HELOC fund for one purpose at a time, whenever possible.
5. Deducting interest when the HELOC is not secured by the same home on which you spent the money

According to the IRS, in order to take the deduction, you must not only spend the money to buy, build, or substantially improve your home, the HELOC must be secured by that home. If the HELOC is secured by a different real estate property, the interest on your HELOC is not deductible.

6. Deducting interest on loans over the IRS limits
Even if you use HELOC funds for qualifying purposes, the amount of the 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 deduct interest on only up to $100,000 of home equity debt. If you have a home equity line of credit balance of more than $100,000, you can deduct interest only on $100,000 of that debt.
  • $750,000 cap on total mortgage debt: You can generally deduct interest only on your first $750,000 of mortgage debt, including first mortgages and HELOCs. The cap is higher—$1 million—if you obtained the qualifying mortgage debt and HELOCs before Dec. 15, 2017. 
Total debt limit based on the purchase price of the home: In addition to the above caps, you can deduct interest only on your total home mortgage debt. That includes your first mortgage and any HELOC, up to the total amount you paid for your home. So if you paid $250,000 for your home and took out a $25,000 HELOC, you can deduct the interest on only up to $275,000. 

7. Not taking deductions to which you are entitled
Since HELOCs have become more complicated, you might think it's better to not deduct any interest from this loan at all. But being afraid to take legitimate deductions is a costly, and unnecessary, mistake. If you used your HELOC for qualifying expenses to buy, build, or substantially improve your home, these deductions are worth taking, so save your receipts and records. Don't miss out!
8. Considering 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 in the 4% range, so it's still a less expensive way to borrow than a credit card would be," says DiBugnara. "The closing costs are very minimal, they are quick to close on, and they offer an interest-only payment option."

In addition, with a home equity line of credit, you pay interest only on your outstanding balance. You can pay it down when you have extra money, knowing you can take money out again when you need it.

"As long as you're making that money work for you—for instance investing in other property—and your rate of return is greater than your cost of the HELOC, it's a good tool," says DiBugnara. "I think if you're taking out a HELOC for other purposes, you should be conscious that you're not getting a tax break, but that you are using the HELOC for the purpose you got it for."

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