IRS Mortgage Interest Deductions Limited to 100% of Fair Market Value - but market value when?

The interest on home equity loans is tax deductible (subject to income limitations and maximum loan limits), as long as the debt is equal to or less than the Fair Market Value (FMV) of the home. See IRS Pub 936. What does this mean?

Suppose you have a Home Equity Line of Credit (HELOC). There is a line of credit available to you on any given day, but you don't owe any money on the HELOC. Then the value of the house declines. The house was worth $450k; with a $350k mortgage, the bank gave you another $100k line of credit to tap 100% of your "trapped" equity. Then, the housing market tanks, your house is worth $400k, and you decide to access the line of credit to give your kid a down payment for her own home. The debt is now more than the house is worth. Is the interest deductible?

According to the IRS, the test for deductibility is based on the date you open the HELOC (when the bank gives you a contract and a book of checks), not today's FMV or the FMV on the day you actually wrote one of those HELOC checks to borrow money. You take the Fair Market Value of the home, subtract other qualified debt (like purchase money mortgage), and basically determine your equity. If the HELOC line is equal to or less than your equity, on the day you open the HELOC, it's deductible.

(Note: other tax rules may restrict or eliminate deductibility of mortgage interest; I'm only looking at this one aspect). It might be worthwhile to retain documentation of the home's value on that date, although it seems unlikely for the IRS to start auditing people for taking an interest deduction on HELOCs.

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When dealing with an obscure IRS rule, I would not take a stranger's word for what's deductible and what isn't - I'd check with my CPA or with the IRS directly. So don't take this article as tax or financial advice - just an interesting footnote in the weird world of real estate tax rules (like how a loss isn't deductible, but a gain is taxable, and a HELOC'ed car or vacation is deductible, but not if you make more than some arbitrary income limit).