Home equity loans sometimes come with tax benefits. More specifically, the interest paid on the loan could be tax deductible if you use the proceeds to help buy, build or improve your home. Interest may also be deductible if you already own the property used to secure the home equity loan and you use the funds to make substantial home improvements. Keep reading to learn more about the specifics of home equity loan tax deductions.
What is a Home Equity Loan?
A home equity loan is a debt product that acts as a second mortgage. It lets you access cash by tapping into your home equity or the amount of the home you own outright. You can compute your home equity by subtracting your outstanding mortgage balance from your home’s current market value. So, a home worth $425,000 with a mortgage balance of $310,000 has $115,000 in equity.
Most lenders cap the borrowing limit at 85% of your home equity. Using the figures above, you could potentially get a home equity loan of up to $51,250 ($425,000 * .85 – $310,000).
Loan proceeds are disbursed in a lump sum and payable over a set period. Since home equity loans come with fixed interest rates, the monthly loan payments are the same for the duration of the loan term. And you’ll know exactly how much the home equity loan will cost you in interest.
Common Uses for Home Equity Loans
A major upside of home equity loans is the ability to use the loan proceeds however you see fit, as there are no spending restrictions. That said, the most common uses for home equity loans include:
- Debt consolidation: You can use a home equity loan to pay off several high-interest debts. Doing so gives you a single loan payment each month, and you could save a bundle in interest if the rate you receive on the home equity loan is lower than what you’re currently paying.
- Emergency funds: Some homeowners choose to set the funds aside for a rainy day instead of using them right away. (Quick note: A home equity line of credit (HELOC) is generally more suitable in this case since you can pull funds as needed and only pay interest on what you borrow).
- Higher education expenses: It’s not uncommon for parents to take out home equity loans to help cover their children’s higher education expenses. This is especially true if there’s an unmet financial need and student loans or other forms of funding aren’t an option.
- Home improvement projects: This is one of the more popular uses for home equity loans. Home renovation projects can provide several benefits, from improving the aesthetic of your home and making it more livable to increase your home’s value.
- Investment opportunities: Some homeowners leverage home equity loans to expand their real estate portfolios. The loan proceeds can provide the down payment needed to purchase investment properties.
Beyond the common uses mentioned here, these loans are ideal for big-ticket purchases. Or you can use them to get one step closer to meeting pressing financial goals.
Importance of Understanding Tax Deductions
Tax deductions reduce your taxable income and can lower your tax liability when you file. This means you can potentially get a larger refund or keep more of your hard-earned money in your pocket.
Tax Deductibility of Home Equity Loans
Here’s what to know about tax deductions and home equity loans.
IRS Guidelines on Home Equity Loan Deductions
The interest paid on home equity loans is deductible if certain conditions are met. For starters, the loan must be secured by your primary or secondary home. The loan proceeds must be used to buy, build or substantially improve the property. There are also limitations on the total mortgage debt. More on the specifics shortly.
Changes Introduced by the Tax Cuts and Jobs Act of 2017 (TCJA)
The TCJA brought significant changes. Before 2018, the interest on home equity loans was deductible regardless of how the money was used.
Now, the uses are restricted to buying, building, or improving a home.
The cap for deducting interest was also lowered from $1 million to $750,000 for joint filers and to $375,000 for married individuals filing separately.
Specific Criteria for Deductive Eligibility
To recap, for your home equity loan interest to be tax-deductible, you need to meet strict criteria.
- The loan must be secured by your home.
- The loan amount, when combined with your primary mortgage, must not exceed $750,000 or $375,000 if filing separately.
- You must use the loan for home-related expenses like renovations.
Potential Tax Implications for Various Scenarios
Below is a breakdown of the specifics of the tax deduction related to home equity loans.
Deducting Interest for Primary vs. Secondary Homes
- Primary home: The IRS allows you to deduct interest on qualifying expenditures if your mortgage debt, including the home equity loan, does not exceed $750,000.
- Second home: The mortgage debt limit is also $750,000 to qualify for the tax deduction, but the limit excludes home equity loan balances.
It’s also worth noting that the mortgage debt limit is $375,000 per spouse if you file your return separately from your spouse.
Impact of Refinancing on Deductions
When you refinance your mortgage, the interest deduction rules for home equity loans can change. If the refinancing amount stays within the $750,000 limit, the interest is generally deductible if the funds improve the home.
If you opt for a cash-out refinance and use the additional funds for purposes unrelated to the home, such as paying off credit card debt, the interest on that portion is not deductible.
Keep in mind that any new loans secured by your home after Dec 15, 2017, are subject to the same $750,000 cap.
Home Equity Loan Use for Business Purposes
If you use the funds from a home equity loan for business purposes, the interest is not deductible as a home mortgage interest. You need to separate personal use from business use in your tax deductions.
While the interest on home equity loans used for business purposes is not deductible as mortgage interest, it may be deductible as business expenses. Consult with a tax advisor to properly categorize your expenses.
Qualified Expenses for Deduction
Here’s a closer look at the expenses that potentially qualify for the deduction.
Home Improvements
Again, Interest on a home equity loan is deductible if the funds are used for home improvements that substantially increase the property’s value. This includes things like adding a new room, remodeling a kitchen, or installing a swimming pool. Routine maintenance, like painting or minor repairs, does not qualify.
To deduct, ensure you keep detailed records of expenses. Receipts, contracts, and descriptions of the work will be necessary when you file your taxes, proving you used the loan for significant improvements.
Educational Expenses
Using a home equity loan for qualified educational expenses can make the interest deductible. Qualified expenses typically include tuition, fees, and other education-related costs for you, your spouse, or your dependents.
These must be legitimate post-secondary education costs. Tuition payments, school supplies, and even room and board can be included.
It’s important to document all educational expenses clearly, as the IRS may ask for proof to ensure the loan was used appropriately.
Debt Consolidation
You may use a home equity loan to consolidate other debts. If the consolidation includes loans that were originally used for qualified expenses like home improvements or education, then the interest might still be deductible.
To benefit, you must itemize deductions and track the origin of each debt. Being able to show that the consolidated loans were used for qualified purposes is key.
This can sometimes be complex, requiring detailed financial records.
Other Potentially Qualified Expenses
Other expenses that can make interest deductible often relate to investments or certain types of emergency expenses. For example, if you use the loan to buy investment property or fund a small business, the interest might be deductible depending on the circumstances.
Specific rules and regulations apply, so consult a tax professional. Having precise documentation supporting the intended use of the loan is critical. This ensures that you can justify the deduction if questioned by the IRS.
Important Considerations
Required Documentation for Record Keeping Purposes
If you qualify and plan to take advantage of the tax deduction offered on home equity loan interest, it’s vital to keep thorough records. You’ll want to have the following documents stored away in a safe place:
- The loan agreement that details the specifics of your home equity loan
- Invoices and receipts that show how the loan proceeds were used (those related to home improvements should be detailed)
- Bank statements that reflect payments made on the home equity loan
- Copies of past tax filings where you have claimed deductions on home equity loan interest
Doing so helps ensure your claims tax filings are supported in the event you’re audited by the IRS or other issues or discrepancies arise when filing your return.
Preparation and Filing Tips
Here are some additional tips as they relate to tax-deductible interest on home equity loans to help you prepare for tax time:
- Get assistance: Contact a reputable tax professional who can review your documents and determine your eligibility for the tax deduction.
- Know the limits: The IRS allows deductions on mortgage interest for loans up to $750,000. This includes combined amounts from primary and secondary mortgages.
- Use tax software: If you plan to file on your own, tax preparation software often provides guidance on claiming home equity loan interest deductions.
- Double-check your information: Reviewing your entries can help avoid errors and an inadvertent rejection of your return by the IRS.
Common Mistakes to Avoid
To piggyback off the last point, you want to steer clear of the following errors to ensure your deduction is accepted:
- Incorrect calculations: Confirm your combined loan totals do not exceed IRS limits and that the amount of interest you deduct is correct.
- Assumptions regarding deductibility: Only interest from loans used for substantial home improvements is deductible.
- Lack of documentation: Not having the proper records can disqualify your deductions.
- Improper tax forms: Make sure to use the correct tax forms when claiming your deductions.
