Home Equity Loans: One of the advantages of home equity loans and home equity lines of credit (HELOCs) over other borrowing options is its tax deductible feature.
Whenever you borrow on your home’s equity, there is a bonus: The interest you pay yearly is usually tax-deductible up to a limit imposed by government, the same as on your home mortgage. The criteria for claiming that deduction on home equity borrowing are a bit different.
When you take out a personal loan or borrow from a credit card, for instance, you pay a higher interest rate and cannot claim a deduction on your taxes. However, you might be able to deduct the interest you pay on your home equity loan from your federal taxes.
Before deciding to take out a home equity line of credit, it’s brilliant to know whether the interest on your HELOC might be tax-deductible. The federal tax law which was passed in December 2017 changed the rules on mortgage interest deductions. Make sure you get to understand how those changes could affect you before you borrow home equity.
Home equity loans and taxes
For anyone who’s considering taking out a mortgage, the new law imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. From 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans.
The limit is $375,000 for any married taxpayer filing a separate return. These are down from the initial limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to purchase, build or substantially improve the taxpayer’s main home and second home.
If you took out a home equity line of credit at the time you bought your home in order to finance the acquisition of the property, such as an 80-10-10 loan with an 80-percent first mortgage, a 10-percent down payment and a 10-percent home equity loan, that mortgage is seen as “home acquisition debt” by the IRS.
If you took out your home equity line of credit much later to make “substantial” home improvements and it is secured by your home, it is also seen as home acquisition debt and is tax-deductible.
However, after the 2017 tax year, interest on home equity debt for purposes other than “substantial” home improvement will not be deductible anymore. There is also no “grandfathering” provision for existing loans and lines of credit, so 2017 will be the last year for many homeowners to claim this deduction.
Initially, interest on loans or lines up to $100,000 ($50,000 if married filing separately) could be deducted when home equity debt was used regardless of the purpose of the loan.
For Tax Years 2017 and Before
A mortgage can help you purchase a home (or borrow against a property you already own), and it might even provide some tax benefits. The interest you pay might be deductible, but don’t be in a hurry to borrow just for savings on your 1040 – there are maximums and other limitations that might reduce or completely eliminate your ability to deduct interest.
This page covers general guidelines, but tax laws are complex and they constantly change. Verify the details and speak with a tax preparer before you claim a deduction.
Deducting Mortgage Interest
The IRS allows a deduction for interest paid on a loan secured by a first or second home. That includes several commonly-used loans:
- Purchase loans (your primary mortgage when you borrow money to buy a house)
- Home equity loans (also known as a second mortgage), which provide a lump-sum of cash
- Home equity lines of credit, which allow you to spend from a credit line
The deduction has the potentials of making those loans less expensive, and can turbocharge certain strategies like debt consolidation (suddenly the interest you pay becomes tax deductible – not just an expense). However, there are limits to how much you can deduct, and when.
Truly, you’re also using your home as collateral when you get a second mortgage, which means the lender can foreclose on your home if you do not make the payments. Using that money for anything besides home-related expenses means you’re adding a risk where it didn’t previously exist.
First or second home
The deduction is not for investors owning dozens of homes. To qualify, the loan must be on your “first or second” home. If you rent out a property, share it, or use it as an office, your deduction may be affected.
Your loan must be secured by your home. Check with the IRS for details, but this generally means your lender has a lien on your home and can foreclose if you fail to pay. In addition, you need to meet one of the following criteria:
- The debt is from October 13, 1987 or before (known as “grandfathered” debt), or
- Debt was used to buy, build, or improve your home, and the total amount of debt is below $1 million
- The debt was not used to buy, build, or improve your home, and the total amount of debt is below $100,000
In some situations, such as when married filing separately, the amounts are reduced.
No shams: the IRS states “Both you and the lender must intend that the loan be repaid.” This would eliminate any fancy schemes where you try to use a sham transaction to save on taxes. For example, you can’t “borrow” from a family member, deduct the interest, and forget about the loan – the loan must function as a true arm’s length transaction.
Construction loans: if you’re building a home, this deduction might help reduce your costs on a construction loan. The IRS allows you to treat a home under construction as a qualified home for up to 24 months as long as you meet certain criteria.
- Dollar amount: The interest deduction from your home equity loan is not unlimited. The limit is higher for money used to buy, build, or improve your home. For many, that works well. However, if you use the money for any other purpose (like higher education, debt consolidation, or something else), you’re capped at $100,000 of debt. Note that the maximums refer to the size of the loan – not the amount of interest you pay yearly.
- Alternative minimum tax (AMT): If you’re subject to AMT, you may see further limitations. Generally, the deduction is more helpful if you use the money to buy, build, or improve your home.
- Itemizing deductions: The mortgage interest deduction is only available if you itemize, and many people don’t itemize. It’s usually best to take the largest deduction available – if your standard deduction is more than you would get from itemizing, your mortgage interest costs might not offer any tax benefits. If you are not sure if you itemize, check to see if you’ve filed Schedule A. To get above your standard deduction, you might need, for example, a sizeable loan or other expenses to help.
- A deduction isn’t a credit: Some people confuse tax deductions with tax credits. A deduction helps lower the amount of income used to calculate your taxes due. A credit is a dollar-for-dollar reduction in what you owe. A deduction will indirectly reduce your tax bill, but it isn’t nearly as powerful as a tax credit.
How Much can you Claim?
If you’ve borrowed against the equity in your home and you want to know how much interest you’ve paid, ask your lender. You should receive a Form 1098 with details about interest for the year.
Claiming a deduction improperly is problematic: it can lead to tax penalties and interest charges from the IRS. Verify all of the details about your situation (and current tax laws) by reading IRS Publication 936. Remember that tax laws are complicated, and things may have changed since this article was written. Speak with a tax preparer who is familiar with the details of your loan to avoid any problems.