A home equity loan can be a great way for homeowners to access cash for large expenses or to consolidate high-interest debt.
By using the equity they’ve built up in their home as collateral, homeowners can typically access funds at lower interest rates than other types of loans. However, it’s important to understand the tax implications of a home equity loan before taking one out.
What's in this article?
One of the most common questions people have about home equity loans is whether the interest on the loan is tax deductible. In this article, we will explore the tax implications of home equity loans and answer the question of whether the interest is tax deductible.
Understanding the tax implications of a home equity loan is important because what you pay in taxes can impact the overall cost of the loan. By the end of this article, you’ll better understand the tax considerations you should be aware of when considering a home equity loan.
Related Reading: What’s better: Home Equity Line of Credit or Cash-Out Refinance?
What is a home equity loan?
Home equity refers to the difference between the current market value of a home and the outstanding mortgage balance. It represents the portion of the home that the homeowner actually owns.
A home equity loan is a type of loan that allows homeowners to borrow money against the equity in their home. Essentially, the borrower is using their home as collateral for the loan.
Ready To Take Your Next Step?
How a home equity loan works
A home equity loan—sometimes identified as an “HEL”— is typically structured as a lump sum that is paid out to the borrower at the beginning of the loan term.
The borrower then makes regular payments—including principal and interest—to repay the loan over a fixed period of time, usually 30 years.
The interest rates on home equity loans are generally fixed, meaning they do not change over the life of the loan.
Home equity loans are different from home equity lines of credit (HELOCs), which are a type of revolving credit that allows homeowners to borrow against their home equity as needed, rather than taking out a lump sum at the beginning of the loan term.
If you have a mortgage or an HEL or HELOC, deducting the interest paid on those loans from your taxable income requires that you report the amount of interest paid on your tax return, using the IRS Form 1098. Form 1098 is a statement from your lender that shows how much mortgage interest you paid during the previous year.
Related Reading: Learn How to use your home equity for your divorce settlement
Tax deductibility of home equity loan interest
The Tax Cuts and Jobs Act (TCJA) of 2017 changed the way home equity loans and home equity lines of credit are treated for tax purposes.
Prior to the TCJA, homeowners could deduct the interest on an HEL or a HELOC up to $100,000 as an itemized deduction on their federal income tax return. However, the TCJA eliminated this deduction for many homeowners.
Under the new tax law, homeowners can only deduct the interest on a home equity loan or HELOC if the funds are used to buy, build or substantially improve the home that secures the loan.
This means that if the funds are used for other purposes, such as paying off credit card debt or financing a vacation, the interest on the loan is no longer deductible.
Additionally, the TCJA lowered the cap on mortgage interest deductions from $1 million to $750,000 for new mortgages taken out after December 15, 2017. This means that the interest on the first $750,000 of a new mortgage is deductible, but interest on any portion above that limit is not.
Do the same rules apply to HELOC
Although home equity loans and credit lines are two distinct products, the regulations for interest deduction are the same for both.
With a home equity loan, you take out a one-time, fixed-interest loan for a predetermined amount of money. Home equity lines of credit, by contrast, are more adaptable. You can withdraw money from your account at any moment during the draw term, which is typically 10 years long.
A HELOC’s interest rate is variable and fluctuates with market rates.
If you use the money to repair your house, the interest on both is tax deductible under the definition of “purchase, build or significantly enhance.” You’re also required to spend the money on the asset whose equity served as the basis for the loan.
Interest on loans up to $750,000 ($375,000 or more for a married taxpayer filing a separate return) is deductible if you meet the requirements.
It’s worth noting that the new total limit for deductions on all residential debt is $750,000. If you have a mortgage and home equity debt, the amount owed on the mortgage will be included in the $750,000 limit if it is a new mortgage.
Older mortgages (prior to 2018) may still be eligible for the previous $1 million limit (or $500,000 for a married taxpayer filing a separate return).
Related Reading: Bridge Loan vs. HELOC: Which is Best for Me?
How to claim a home equity loan interest deduction:
To claim a home equity loan interest deduction, you will need to follow these steps:
- Determine if you’re eligible: You can claim the home equity loan interest deduction if you’re a homeowner and your loan is secured by your primary residence or a second home. Additionally, you must use the loan proceeds to improve your home or to buy, build or substantially improve your primary or secondary residence.
- Calculate the amount of interest you paid: You can find this information on your Form 1098, which you should receive from your lender at the beginning of each year.
- Determine the maximum deductible amount: The maximum amount of interest you can deduct is $750,000 for loans taken out after December 15, 2017. The maximum amount for loans taken out before that date is $1,000,000.
- Fill out Schedule A: You must itemize your tax return deductions and fill out Schedule A to claim the home equity loan interest deduction.
- File your tax return: Be sure to include all necessary forms and documentation when filing your tax return.
Compass Mortgage Home to a better mortgage experience
The interest on a home equity loan can be tax-deductible if you meet certain requirements
However, it’s important to consult with a tax professional to ensure eligibility and compliance. Overall, if you’re eligible for this deduction, it can provide valuable tax benefits.
Looking to buy a new home or refinance your existing mortgage? Look no further than Compass Mortgage.
We are the home to a better mortgage experience! Our team is committed to providing you with top-notch service and personalized solutions tailored to your unique needs.
Whether you’re a first-time homebuyer or a seasoned homeowner, we can help you find the perfect mortgage option to meet your goals.
Our Get Committed® loan commitment program and expert guidance will make your mortgage process simple and stress-free.
Apply now to get started — and Get Committed® — with Compass Mortgage today.
Photo by Monstera