A home equity loan can be a great way to use the equity in your home for a variety of different purchases. In addition to using the money for home improvement projects, many people use home equity loans to finance debt consolidation or other major purchases like investments or higher education.
Although interest paid on home equity loans may be tax deductible, there are certain limits. To be tax deductible, you must use the home equity loan to “purchase, build, or substantially improve” the home that was used to secure the loan.
Is the interest on my mortgage tax deductible?
Whether or not you can deduct the interest paid on your home equity loan depends on when you took out your loan, how much you borrowed and how you use the funds.
With the passage of the Tax Cuts and Jobs Act of 2017, joint filers who took out their home equity loan after December 15, 2017 can deduct interest on up to $750,000 of qualified loans , while separate filers can deduct interest on up to $375,000. However, the loan funds must be used to “purchase, build, or substantially improve” the home that was used to secure the loan. This means you can no longer deduct interest on home equity loans you use to pay off debt or meet an emergency expense.
These limits also include all currently outstanding mortgages. For example, if you still have a mortgage balance of $500,000, only $250,000 of home equity loans will be eligible for tax deductions.
If you took out your home equity loan before December 15, 2017, your limits are higher at $1 million for joint filers and $500,000 for separate filers, as long as the funds were used to buy, build or improve the house.
Let’s say you took out a home equity loan in 2022 for $200,000. Half of this loan was used to consolidate credit card debt, while the other half was used to build a new home office. In this scenario, the interest you paid on the $100,000 used for your home renovation would be tax deductible, but the interest you paid on the $100,000 used for debt consolidation would not. .
If you have a home equity loan, here’s how to find out if you can deduct the interest.
Check the details of both mortgages
The first loan you took out to buy the house is your first mortgage, and the mortgage loan is your second mortgage. Both mortgages must meet IRS requirements. Combined, the debt must:
- Not to exceed $750,000 or $1 million, depending on when the loans were taken out.
- Be secured by a “qualified residence”, which can be your main residence or your secondary residence.
- Do not exceed the value of the residence(s).
- Will be used to acquire or substantially improve the residence(s).
You can find the dollar amount of your mortgage and home equity loan on your most recent billing statements or by calling your loan manager.
What was the loan used for?
Next, check to see if the home equity loan was used to buy, build or improve your home. Here is a rule of thumb: a “substantial” improvement is one that adds value to the home, extends its useful life or adapts a dwelling to a new use. Although the IRS does not offer a comprehensive catalog of expenses that fit this description, here are some examples:
- Build an annex to the house
- Installation of a new roof
- Replacement of an HVAC system.
- Carrying out a large kitchen renovation project
- Resurfacing the driveway
Itemize your deductions
To take advantage of this tax relief, you will need to itemize your deductions at tax time. It’s only worth it if all of your deductions total more than the standard deduction amount for the 2021 tax year:
- $25,100 for married couples filing jointly.
- $12,550 for single filers or married filers filing separately.
- $18,800 for the head of household.
You can either take the standard deduction or itemize – not both. After totaling up your itemized expenses, including interest on your home loan, and comparing it to your standard deduction, you need to decide if the breakdown is to your advantage.
For example, let’s say you paid $2,600 in interest on a home loan and $9,100 in interest on your mortgage in 2021. You file a joint return, and those are the only deductions you can itemize for a combined value of $11,700. Because $11,700 is far less than the standard deduction of $24,800, it doesn’t make sense to itemize just so you can deduct the interest you paid. However, it’s always wise to speak to a tax professional to explore your options before proceeding.
According to a report by the policy research organization The Tax foundation. But if you end up getting the home equity loan interest deduction, it will be claimed on the IRS tax form. Appendix A, Detailed Deductions.
Gather your documents
To deduct interest from a home loan on your tax return, you will need to gather the following documents:
- Mortgage Interest Statement (Form 1098). This form is provided by your home equity lender and shows the total amount of interest paid during the previous tax year.
- Statement of additional interest paid, if any. If you paid more home loan interest than what is shown on your Form 1098, you will need to attach a statement to your tax return with the additional amount of interest paid and an explanation for the difference.
- Evidence of how the equity in the property was used. Keep receipts and invoices for all expenses that significantly improve the value, longevity, or adaptability of your home. This includes the costs of materials, labor and permits needed for the upgrade.
Other Benefits of Home Equity Loans and HELOCs
Being able to deduct interest paid on a home equity loan or HELOC is just one of the benefits associated with these types of loans. Some of the additional benefits include:
- Attractive interest rate. These loans generally offer lower interest rates than unsecured debt, such as credit cards or personal loans.
- Long repayment periods. The repayment terms for HELOCs and home equity loans range from 10 years to 30 years.
- Large lump sums. Home equity loans and HELOCs can be a quick and easy way to access a large sum of money to pay for major expenses.
Key points to remember
- Joint filers who took out a home equity loan after December 15, 2017 can still deduct interest on up to $750,000 of qualified loans, while single filers can deduct interest on up to $375,000. The loan proceeds, however, must be used to “purchase, build or substantially improve” the home that was used to secure the loan.
- Substantial improvements are those that add value to the home, extend its useful life, or adapt a home to a new use.
- To take advantage of this tax relief, you will need to itemize your deductions at tax time.