A home equity loan is a type of loan that uses the equity in your home as collateral. If you use the proceeds of the loan for what the IRS deems to be “substantial improvements” to your home and meet other criteria, home equity loan interest may still be tax-deductible to an extent. Understanding the potential and limits of the mortgage interest deduction can help you properly deduct home equity loan interest and reduce your tax bill.
The Mortgage Interest Deduction and Home Equity Loans
Home equity loan interest tax deductions are one of the multiple mortgage-related interest tax deductions that you may be able to claim. A mortgage can help you buy a home or borrow against a property you already own in the case of a home equity loan. It might even provide some tax benefits since the interest you pay is sometimes deductible. Under the home mortgage interest deduction, the IRS allows you to deduct the interest you pay on any type of home loan when it is secured by your main home or a second home, including:
Purchase loans (your primary mortgage when you borrow money to buy a house) Home equity loans (often used as a second mortgage), which provide a lump sum of cash Home equity lines of credit (HELOCs), which allow you to spend from a credit line
Deducting Home Equity Loan Interest on Your Taxes
Mortgage interest on a home equity loan is generally only tax-deductible when you meet certain conditions.
First or Second Home
The home mortgage interest deduction isn’t for investors who own dozens of homes. To qualify, the loan must be for your first or second home. If you rent out a property, share it, or use it as an office, your deduction will be limited.
Loan Criteria
Your loan must be secured by your first or second home. This generally means your lender has a lien on your home and can foreclose on it if you fail to pay your loan.
Substantial Improvements
The interest you pay on your home equity loan is only deductible if you use the loan proceeds to “buy, build, or substantially improve” the home that secures the loan. For example, this means that you could take the mortgage interest deduction for a home equity loan you use to add a room to your home but can’t take it if you use the loan proceeds to pay off credit card debt.
You Must Intend To Repay the Loan
The IRS states that “both you and the lender must intend that the loan be repaid.” This eliminates schemes such as using 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 Loan
If you’re building a first or second home, you can still treat it as a qualified home for 24 months and take the mortgage interest deduction if it becomes a qualified home after construction is completed.
Limits When Deducting Home Equity Loan Interest
Don’t rush to take out a loan just for savings at tax time. There are maximums and other limitations that might reduce or completely eliminate your ability to deduct the interest.
Dollar Amount
Generally, the dollar limit for the mortgage interest deduction is lower for loans that were taken out after 2017. If you use the money for another purpose (like higher education or debt consolidation), your deduction will be limited. The mortgage interest you pay is fully deductible if you meet at least one of the following criteria:
Itemizing Deductions
The mortgage interest deduction is only available if you itemize your deductions, which many people don’t do. If you’re not sure whether you itemize, see if you’ve filed Schedule A of Form 1040. It’s typically best to take the largest deduction available. If your standard deduction is considerably more than you’d get from itemizing, then itemizing for the sake of deducting mortgage interest costs might not offer any tax benefits. To get more than your standard deduction, you might need a sizable loan or other expenses to help (such as high medical expenses, for example).
Deduction vs. Credit
Some people confuse tax deductions with tax credits. A tax deduction helps to lower the amount of income used to calculate your tax bill. A tax credit is a dollar-for-dollar reduction in what you owe on your tax bill. The mortgage interest deduction will help lower your taxable income but it’s not as powerful as other tax credits.
Should You Deduct Home Equity Loan Interest?
Under the home mortgage interest deduction, the home equity loan interest you pay is tax-deductible in certain cases. You just need to make sure you use the loan proceeds to make improvements to your house. A home equity loan is not meant to just help you save money on your taxes. Home equity loans can also be risky because using your home as collateral when you take out a second mortgage means that a lender can foreclose on your home if you don’t make the payments. Claiming the mortgage interest deduction improperly can also lead to tax penalties from the IRS, so verify all of the details about your situation by reading IRS Publication 936. And remember, tax laws frequently change. Speaking with someone you trust who is familiar with the details of your home equity loan and taxes can help you avoid any problems when taking this tax deduction.
