A home equity loan is a loan using your home as collateral – a somewhat risky move, but worthwhile in certain circumstances. Additionally, you may be able to deduct the interest you pay on a home equity loan as long as you meet certain conditions. Taxpayers who itemize deductions on their returns, spend the proceeds of a home equity loan to buy, build, or substantially improve the property, and do not have too much total mortgage debt may qualify for this deduction.
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Home Equity Lending Basics
Home equity loans use the equity in the borrower’s home as collateral. Taking out a home loan is therefore putting the borrower’s home at risk. If the borrower defaults on the loan, the lender can foreclose and sell the home to pay off the debt.
Home equity loans generally carry lower interest rates than other loans, such as unsecured personal loans, but may involve higher fees and other costs. And they’re only available to homeowners who have enough equity in their home to meet lenders’ loan-to-value (LTV) requirements. LTV references generally limit loans to 80% of the home’s appraised value.
Regular home equity loans advance the borrower a single lump sum in cash. Home equity lines of credit (HELOCs) allow borrowers to withdraw cash whenever they want up to the amount of the loan. HELOC borrowers only pay interest on funds actually advanced.
Mortgage Interest Deduction Basics
The mortgage interest deduction allows homeowners who borrowed to buy their home to deduct the interest paid in a year from their taxable income for that year. However, only owners who itemize deductions can claim this deduction. Many opt instead for the standard deduction, which for 2022 is $12,950 for single filers and married filers filing separately, $25,900 for joint filers and $19,400 for heads of families.
The tax law also only allows mortgage interest deductions on a maximum of $750,000 of mortgage debt. An upper limit of $1 million applies to mortgages entered into before December 16, 2017. The limit applies to total mortgage debt on up to two residences.
Home Equity Loan Interest Deduction
The IRS rules for home equity loans are similar in some ways to those for the original loans used to buy the home, such as filers who want to deduct interest on an original mortgage, home equity borrowers must itemize. Interest deductions on home equity loans are limited to the same total mortgage debt of $750,000. And interest deductions on home equity loans can also only be claimed on qualified residences, which generally allows for a first and second home.
The big difference with home equity loan interest deductions is that they can only be claimed when loan proceeds are used to buy, build or significantly improve the property.
If a borrower uses the loan for other purposes, such as paying off a high-interest credit card balance, the interest is not deductible.
Also, the loan must be secured by the home being purchased, built or improved. If a borrower uses a home loan secured by a principal residence to buy, build or improve a vacation home, the interest is not deductible.
The tax rules do not precisely define what amounts to a substantial improvement. However, it is generally understood as a permanent improvement that increases the value of the house. Examples include:
Adding a room, such as a bedroom, bathroom, or home office
Replacement of a roof
Build a swimming pool
Upgrading or replacing a heating or air conditioning system
Installation of windows
Less permanent upgrades may not qualify. For example, repainting a room would probably not be deductible. Note that the borrower must be able to associate the home equity loan proceeds with a specific improvement and keep receipts to substantiate the cost.
The mortgage limit of $750,000 applies to all loans taken out on the house or houses. So a borrower with a primary residence and a vacation home who owes a total of $500,000 on both homes could only deduct interest on a home equity loan of $250,000 or less. If a larger home equity loan is taken out, interest would only be deductible on up to $750,000 of loans.
Home Equity Loan Alternatives
Alternatives to a home equity loan may be preferable. For example, paying for improvements with an unsecured personal loan avoids putting the home at risk, although the interest on the personal loan is likely higher and also non-deductible. A cash refinance is another option. A homeowner who refinances in cash takes out a new loan for more than the balance of the original mortgage and pockets what’s left over after paying off the original mortgage.
Interest paid on the refinance loan amount used to pay off the original mortgage is tax deductible as long as the taxpayer details and owes no more than $750,000 in total mortgages. After paying off the original mortgage, other funds from a cash refinance are, like home equity loans, tax deductible only to the extent they are used to purchase, build or substantially improve a qualifying residence the loan.
Interest on home equity loans may be deductible if the taxpayer itemizes, owes no more than $750,000 in total mortgage debt and uses the proceeds to purchase, build or substantially improve the property. Improvements must be made to the property securing the loan. Other restrictions limit the deductibility of interest on a maximum of $750,000 in total mortgages.
Financial Planning Tips
A financial advisor can help you with home equity loans or any other financial problem. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
To see what your income tax payment might look like, use SmartAsset’s free tax calculator.
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Are home equity loans tax deductible? appeared first on SmartAsset Blog.