Are Home Equity Loans Tax-Deductible?

One significant advantage of home equity loans compared to other forms of financing is the potential for their interest to be tax-deductible, though this is subject to specific conditions. The deductibility of the interest depends on factors such as the time the loan was obtained and, crucially, the intended purpose of the borrowed funds.

Is the interest on home equity loans tax deductible?

To clarify, only the interest accrued on a home equity loan is eligible for tax deduction, not the principal amount borrowed. Whether you can deduct this interest depends on factors such as the timing of the loan, the loan amount, the purpose of the funds, and whether it’s more advantageous to itemize deductions or opt for the standard deduction.

What are the rules and limitations of home equity tax deductions?

Until six years ago, homeowners could use home equity loans for various purposes and deduct the annual interest paid on their tax returns. However, with the enactment of the Tax Cuts and Jobs Act of 2017, significant changes were introduced.

Firstly, the Act restricted the tax-deductibility of interest to loans used specifically to “buy, build, or substantially improve” the primary or secondary home securing the loan. This means interest on home equity loans used for purposes unrelated to home improvements, such as debt consolidation or business ventures, is no longer deductible.

Secondly, the Act imposed limits on the amount of interest that can be deducted. For loans taken out after December 15, 2017, joint filers can deduct interest on up to $750,000 of qualified loans, while separate filers and singles can deduct interest on up to $375,000. Loans taken out before this date have higher limits: $1 million for joint filers and $500,000 for separate filers and singles.

These limits also include the combined total of mortgage loans outstanding. For instance, if a homeowner has a remaining mortgage balance of $500,000, only $250,000 of additional home equity loan debt would qualify for tax deduction under the new regulations.

Are HELOCs also tax-deductible?

The tax deductibility of home equity lines of credit (HELOCs) hinges on specific criteria. To qualify for deduction, the funds must be used to buy, build, or substantially improve the home securing the loan.

Certain expenditures render HELOC interest non-deductible. These include using the funds to pay off student loans, cover college tuition expenses, or consolidate credit card debt.

Interest on a HELOC can be deducted if it is used to acquire a second or vacation home, provided that this home serves as collateral for the debt. For instance, you cannot deduct the interest if you open a HELOC on your primary residence and use the funds to purchase or renovate a separate beach house. The same rules apply to home equity loans.

How to claim a home equity loan interest deduction

1. Know where you stand with both mortgages

The loan used to purchase your home is typically referred to as your first mortgage, while a home equity loan represents a second mortgage. Both mortgages must adhere to IRS guidelines.

Collectively, the debt must:

• Not exceed specified limits depending on when the loans were initiated ($750,000 or $1 million)
• Be secured by a “qualified residence,” which could be your primary or secondary home
• Not surpass the value of the residence(s)
• Have been utilized to acquire or substantially enhance the residence(s)

To ascertain the amounts of your mortgage and home equity loan, consult your most recent billing statements or contact your loan servicer.

Additionally, verify if the home equity loan was employed to purchase, construct, or upgrade your home. As a rule of thumb, a “substantial” improvement enhances home value, extends its useful life, or adapts it for a new purpose.

While the IRS doesn’t provide an exhaustive list of qualifying expenses, examples include:

• Constructing an addition to the home
• Installing a new roof
• Upgrading an HVAC system
• Extensively renovating a kitchen
• Resurfacing a driveway

2. Gather your documents

To claim home equity loan interest on your tax return, gather the following documents:

• Mortgage interest statement (Form 1098): This document is provided by your home equity loan lender and details the total interest paid in the previous tax year.
• Statement for additional interest paid, if applicable: If you paid more interest on your home equity loan than what’s reported on Form 1098, you should include a statement with your tax return that explains the additional interest paid and provides the exact amount.
• Proof of how home equity funds were used: Maintain receipts and invoices for expenses related to improvements that significantly enhance the value, durability, or utility of your home. This includes costs for materials, labor, and any permits required for renovations or repairs.

3. Itemize your deductions

To benefit from this tax benefit, you must itemize your deductions when filing your taxes. It’s worthwhile only if your total deductions exceed the standard deduction amount for the applicable tax year. You have the option to either take the standard deduction or itemize deductions, but not both.

The standard deduction amounts are significantly increased by the Tax Cuts and Jobs Act:

Add up all your itemized expenses, including the interest on your home equity loan, and compare them with your standard deduction. Then, you can determine whether itemizing your deductions is advantageous.

For example, suppose you paid $2,600 in interest on a home equity loan and $9,100 in mortgage interest in 2022. If you’re filing a joint return and these are your only itemized deductions, they total $11,700. Given that $11,700 is much lower than the standard deduction of $25,900, it wouldn’t be beneficial to itemize just to claim the interest you paid.

If you decide to deduct the interest on your home equity loan, you would report it on IRS tax form Schedule A, Itemized Deductions.

In Conclusion

The interest paid on a home equity loan can be tax-deductible if the funds were used to purchase, build, or improve a home, as defined by the IRS. However, if the total interest on your first mortgage and home equity loan, along with other itemized deductions like state and local taxes, is less than the standard deduction for the tax year, it’s typically more advantageous to take the higher standard deduction instead of itemizing.

When making decisions about your taxes, it’s always wise to seek advice from a tax professional.

Even without the tax deduction, taking out a home equity line of credit (HELOC) or home equity loan can still be a wise financial move. Because these forms of financing are secured by your home, they generally offer lower interest rates compared to credit cards or personal loans. Using a home equity loan or HELOC to pay off higher-interest debt can be a smart investment, freeing up funds for savings or investments.