If you’re a homeowner, you already know that some of your mortgage interest may be tax-deductible. But does the same benefit exist if you have equity in your home and want to borrow against it?
At CMP, we work with homeowners every day to help them maximize the tax benefits of homeownership, ensuring that they take every deduction and tax credit that’s available to them. One of the questions we hear most often is this:
Before you get a home equity loan, it’s important to ask that question to be sure that you understand your financial rights and obligations. Here’s what you need to know about home equity loans and your taxes.
A home equity loan is a loan that uses the equity in your home as collateral. If you bought your home with a significant down payment of 20% or more, you likely already have equity in your home. Without a large down payment, you can accrue equity by paying your mortgage each month, or when the real estate market is on an upward swing. A home equity loan may also be referred to as a second mortgage.
Because you have used your home as collateral, the lender will need to be repaid when you sell your home. It’s a common misconception that the money from a home equity loan needs to be used for home improvements. That’s not the case. You can use a home equity loan to consolidate debt, buy a car, or even pay for your child’s college education. The way you use money will dictate whether you can deduct what you pay in interest.
For many people who have home equity, the decision to be made is between a home equity loan and a home equity line of credit (HELOC). There are advantages to each, and we’ll talk about the tax advantages of home equity loans vs HELOCs later in this post.
A home equity loan is like a mortgage in many ways because it uses your home as collateral. You will need to go through an application and underwriting process with your lender.
The basic requirements for a home equity loan are as follows:
If you meet these requirements, and your loan is approved, you will receive the money as a lump sum. As we stated above, the money from a home equity loan can be used for any purpose you choose.
It is common for the term of a home equity loan to be shorter than the standard 30-year mortgage term, and the term may be as short as five or 10 years. However, some home equity loans may have 15- or 20-year terms.
You do not need to repay your home equity loan to sell your house. Your lender will have a lien on your home that will need to be released at the time of the sale and will be released when they are repaid.
The biggest benefit of a home equity loan is that it can give you the money you need, allowing you to repay with predictable monthly payments.
Since the interest on any loan can add up quickly, it’s natural to want to save money wherever you can. Our clients often ask us about interest deductibility on mortgages and other home loans.
The Tax Cuts and Jobs Act of 2017 suspended the deduction for home equity loan interest from 2018 through 2026. However, there is one important exception that you should know about.
According to the Internal Revenue Service, interest for home equity loans is still deductible if you use the funds from the loan to:
buy, build, or substantially improve the taxpayer’s home that secures the loan.
So, while you may use the funds from a home equity loan for any purpose, if you do not use them to improve your home, the interest is not tax-deductible.
Let’s clarify what counts as a substantial improvement to your home. Here are some examples:
As a rule, if you make improvements that add to the value of your home or extend its life, then your home equity loan interest will be tax deductible up to the allowable limit. If you only use part of the loan on home improvements, you should calculate your tax deduction accordingly.
The one exception is if you have a loan that you took out on or before October 31, 1987. If your loan qualifies, then it is grandfathered in under the old rules and you may deduct the mortgage interest accordingly.
A question related to the tax deduction for home equity loan interest is about rental properties. If you own an investment property that you rent out, can you deduct the interest on your home equity loan?
The answer is a qualified YES. You may deduct the interest if you meet the following qualifications:
You’ll need to keep careful records of your expenditures and be prepared to present those records to your accountant and the IRS in the event you are audited.
Another question that we hear a lot from clients who want to borrow against their home equity is whether there is any tax advantage to choosing a home equity loan instead of a HELOC or vice versa.
The short answer is that the same rules apply to the interest on a HELOC that apply to the interest you pay on a home equity loan. Both are tax-deductible if you spend the money on substantial improvements to the home that you used as collateral to borrow the money.
As we noted above, the Tax Cuts and Jobs Act of 2017 suspended interest deductions for home equity borrowing from 2018 to 2026. However, the deduction may still be taken if you use the money to increase the value of your home. If you use it for any other purpose, then the deduction does not apply.
Since the tax value of a home equity loan and a HELOC are the same in terms of deducting the interest you pay, the choice comes down to which form of borrowing is best suited to your needs.
Many people prefer a HELOC because they have the freedom to withdraw money as they need it, and they pay for only what they use. With a home equity loan, you get a lump sum payment and must pay interest on the entire amount of the loan.
Another benefit of a HELOC is that the credit is revolving, which means that you can withdraw funds, pay them back, and withdraw them again provided you do so within the limits of your lending agreement. Most HELOCs have a window for borrowing and a term at the end during which anything you borrow must be repaid.
Now, let’s talk about the limitations that exist for home equity loan interest tax deductions. The IRS has put limits in place and before you attempt to deduct your interest, you should know what they are.
In addition to changing the rules for when home equity loan interest can be deducted on your taxes, the Tax Cuts and Jobs Act of 2017 also reduced the amount of interest that is deductible.
The limits as of 2022 include:
Let’s look at a couple of scenarios to explain what this means for your taxes.
Example A: A homeowner takes out a mortgage of $500,000 to buy a home. They then take out a home equity loan of $200,000. The total of the two loans is $700,000, so they would be able to deduct the entire amount of interest paid on the two loans.
Example B: A homeowner buys a home with a $600,000 mortgage and takes out a $250,000 home equity loan to improve the home. They can deduct all the interest on their first loan and a portion of the interest on the second loan.
We should note that these limits represented a decrease. The limit previously allowed for the deduction of interest up to $1,000,000.
Now that you understand when home equity loan interest is deductible and how much you can deduct, let’s walk through the steps required to claim the home equity interest tax deduction.
The first thing you should know is that you cannot take the home equity interest tax deduction and the standard deduction. You must itemize your deductions if you want to deduct your loan interest.
According to IRS Publication 936, you must do the following things to start:
Here are the steps to follow.
As you can see, the process is not complicated. However, we do recommend working with an experienced tax professional to make sure you claim all available deductions and credits.
If you take out a home equity loan or HELOC and use the funds to improve your home, you are eligible to claim a tax deduction up to the allowable limit. Doing so can help you lower your tax bill. We also offer tax and accounting services for real estate & construction businesses. Do you need someone to help you minimize your taxes? CMP is here to help!