Home Equity Loan Tax Deductions Explained     – CNET

Home Equity Loan Tax Deductions Explained – CNET

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One major benefit of a home equity loan is that the interest is tax deductible, provided that the loan is used for home improvements or renovations. 

Borrowing against your home equity can be an effective way to access cash to pay for major life expenses, such as eliminating credit card debt or paying college tuition. But when you use a home equity loan or home equity line of credit for expenses outside of the house, the tax deduction no longer applies. That’s why using either a home equity loan or HELOC for home repairs or upgrades is considered a better use of your loan compared with using it to pay for other expenses. 

Here’s what you need to know about when you qualify to deduct the interest on a home equity loan.

What is a home equity loan?

Your home equity is the difference between what you still owe on your mortgage and the current value of your home. You build your home equity by making consistent monthly mortgage payments over the years. When you take out a home equity loan, you’re borrowing against that equity, which means that your house serves as collateral to secure the loan. That’s why it’s important to carefully consider if a home equity loan is the right choice for you; if you can’t pay back your loan, your lender can repossess your property to fulfill the debt you owe. 

A home equity loan provides you with a lump sum of cash at a fixed-interest rate that you pay off on a fixed schedule. Your monthly payments will always be predictable and your rate will never go up. Most lenders want you to have at least 15% to 20% of equity in your home before they approve you for the home equity loan, which is a second mortgage on your house.

Although homeowners use home equity loans for a variety of expenses, the intended purpose is for home repairs and improvements. It’s the only IRS-approved reason you can deduct your interest, which will save you thousands of dollars over the lifetime of your loan. There’s less incentive to use a home equity loan for other purposes because those tax benefits won’t apply.

How is home equity loan interest tax deductible?

The IRS states that interest on a home equity loan is deductible if the money is used to “buy, build or substantially improve your home.” The loan must be taken out on your primary or secondary residence and needs to be either a “house, condominium, cooperative, mobile home, house trailer, boat or similar property that has sleeping, cooking and toilet facilities,” the IRS says. If you have additional investment properties, whether you can deduct the interest will depend on what business purpose it serves.  

To determine whether or not your home equity loan will qualify for the deduction, use the IRS Interactive Tax Assistant by inputting some basic information about your mortgage.

Whether you file your taxes jointly or individually has an impact on how much of your home equity loan interest you can deduct. When the Tax Cuts and Jobs Act of 2017 went into effect on Jan. 1, 2018, it changed the loan limits for home equity deductions, with different thresholds for those filing jointly and those filing separately.

If you took out your home equity loan after Dec. 15, 2017, joint filers can deduct interest of up to $750,000 ($375,000 for single filers). If, however, your loan closed before that date, your limits will be higher, with joint filers deducting interest on up to $1 million and single filers up to $500,000 worth of loans.

How much home equity loan interest is tax deductible?

Filing status When the home equity loan closed The amount of debt you can deduct interest on
Filing jointly After Dec. 15, 2017 Up to $750,000
Filing jointly Before Dec. 15, 2017 Up to $1 million
Filing separately After Dec. 15, 2017 Up to $375,000
Filing separately Before Dec. 15, 2017 Up to $500,000

The determining factors for how much of your loan you can deduct the interest on is based on whether you took out your loan before or after 2018, how much money you borrowed and what you’re using the funds for.

Know the limitations of tax deductions on home equity loans

Interest on a home equity loan is deductible only if the borrowed funds are used to buy, build or significantly improve your property. So if you want to borrow against your equity to pay for other kinds of life expenses, you’ll be on the hook for paying back your loan interest. Until 2018, homeowners were able to deduct their home equity loan interest for other expenses such as paying off credit card debt or emergency medical bills, but those expenses became exempt when the tax laws changed.

Keep in mind, in order to qualify for the tax deduction, you must itemize your deductions rather than taking the standard deduction.

3 steps to claim home equity loan interest deduction

In most cases, it’s easier to work with an accountant who’s knowledgeable on the most recent tax deduction rules and regulations to claim your deduction. Regardless of how you file, you’ll need to get all of your financial paperwork ready to go.

1. Know where you stand with your mortgages

You’ll want to make sure the combined debt from your first mortgage and your home equity loan, which is your second mortgage, meets IRS requirements and doesn’t exceed $750,000 or $1 million for joint filers, or $375,000 or $500,000 for single filers, depending on whether you took out your loan before or after 2018. You also need to make sure that you’re borrowing against a qualified residence, which should be either your primary or second home, and that the funds were used to increase the value of your property through renovations or upgrades such as a new roof.

2. Compile your documents

You’ll need to fill out Form 1098, which should be provided to you by your lender, as well as gather proof of how you spent your loan funds to show the IRS you did indeed complete substantial renovations on your home. Keep track of items such as receipts and bills from contractors so you can claim your interest deduction. 

3. Itemize your deductions

To qualify for the home equity loan interest tax deduction, you must itemize your deductions instead of taking the standard deduction. If you don’t have an accountant to file your taxes, you’ll need to make sure you file all of the proper IRS forms on your own. For example, in addition to Form 1098, you may need to file Form 1040 or 1040-SR to itemize your deductions.

FAQs

Is it worth applying for a home equity loan or HELOC just to get the tax deduction?

You should only apply for a home equity loan or HELOC if you actually need a loan and it’s the best way to finance your expenses. If you’re not using the loan for home improvements, you won’t qualify to deduct the interest, anyway.

What expenses are applicable to deducting HELOC interest?

The only expenses applicable to deducting HELOC interest are when you use it to “buy, build, or substantially improve” the home that secures the loan, according to the IRS. You can’t deduct your loan interest if you use your loan to start a business, for example.

The bottom line 

The interest on a home equity loan or a HELOC is only tax deductible if you use the money for home repairs or renovations like building an addition on your home. That’s why using a home equity loan or HELOC specifically for home improvements is considered the best use of a home equity loan — you receive tax benefits that aren’t available when you use the money for other purposes. To claim the home equity loan interest deduction, be prepared to itemize your taxes and provide proof of how you used the loan through items like receipts and invoices from contractors or builders.

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Alix Langone

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