Are Home Equity Loans Tax Deductible?
A home equity loan allows you to access the money you've already invested in your home. Consolidating high-interest debt, financing a home addition to accommodate your growing family or defraying the cost of your child's college education are all practical reasons to borrow against your home equity. There may be another added benefit, too: the interest that you pay on a home equity loan is tax-deductible in certain circumstances.
Read on to learn more about whether home equity loans are tax deductible, how to claim a deduction and other similar options.
Can interest from a home equity loan be tax deductible?
The short answer to this question is yes, but with limitations. The interest on your home equity loan may be tax-deductible depending on your mortgage debt, when you got the loan and how you used it.
The amount of interest that is deductible
The Tax Cuts and Jobs Act (TCJA) of 2017 decreased the maximum amount of tax-deductible interest. If you took out your home equity loan before December 15, 2017, you can deduct interest on up to $1 million of debt if filing jointly and up to $500,000 of debt if filing separately.
Joint filers who borrowed after that date can deduct interest on up to $750,000 of debt, and married people who file on their own can deduct interest on up to $375,000 of debt.
The rules for home equity loan tax deductions
In order for interest to be tax-deductible on a home equity loan, you must have used the funds from the loan to "buy, build or substantially improve a taxpayer’s home that secures the loan," according to the IRS. That is, you must use the money to make improvements that increase the value of your home, otherwise the interest on the home equity loan is not tax-deductible.
For example, you might take out a $100,000 home equity loan and use half of it to pay off your graduate school debt and the other half for a kitchen renovation. In that case, the interest on the $50,000 that you used for home improvement would be deductible, but the interest on the other $50,000 wouldn't be.
Either your primary residence or your second property can be a "qualified residence" for a home equity loan tax deduction.
What's needed to claim a deduction?
When it's time for tax filing season, you'll need to gather the following documents in order to claim a home equity loan interest deduction on your tax return:
- Mortgage interest statement (Form 1098) - Your lender provides this document to show the amount of interest you paid during the tax year.
- Proof of how you used home equity loan funds - Keep receipts and invoices for any home improvement expenses. This includes costs of labor, materials and any required permits.
- Statement for additional interest paid, if necessary - If there's a difference between the amount shown on your Form 1098 and the amount of interest you actually paid during the year, you may need to attach a statement showing the correct amount and explaining the discrepancy.
- Closing disclosure, mortgage statement, and mortgage deed - These sirve to prove how much you borrowed when you bought your home.
How to claim a home equity loan interest deduction
The key to deducting your home equity loan interest is having proper documentation and understanding the IRS's rules.
1. Make sure your loan qualifies - The first step is to know where you stand with your debt. Ensure that:
- The total amount of any loan taken out on your home — whether that’s from your first mortgage or your home equity loan (also known as a second mortgage — doesn’t exceed the IRS's limits of $750,000 for joint filers and $375,000 for single filers.
- Remember that your limit also depends on when you took out your loans, whether before or after the TCJA.
- A "qualified residence" secures the home equity loan. This can be either your main home or your second home.
- Your total amount of mortgage and home equity loan debt doesn’t exceed the value of your home(s).
- You used home equity loan funds to acquire or substantially improve a qualified residence. Though the IRS doesn't offer a full list of expenses that fit that description, a few examples might include: installing a new roof, adding a bedroom or bathroom to the home, resurfacing the driveway or replacing an HVAC system. Standard home repairs that don't improve the value of your home, such as fixing a damaged roof or repairing a cracked foundation, won't qualify for the deduction.
2. Gather the necessary documents - Collect the documents listed in the section above.
3. Consider your mortgage points - If you purchased your main home this tax year, you may be able to factor in your mortgage points as a deduction. The exact amount depends on whether you paid these in cash or rolled them into your loan. To learn more, check in with your mortgage originator and tax advisor.
4. Itemize your deductions - To get a home equity loan tax write-off, you must itemize your deductions. However, this is only worthwhile if your itemized deductions total more than the standard deductions for the 2022 tax year, which are $25,900 for married couples filing jointly and $12,950 for single filers.
You must choose between the standard deduction and itemized deductions. You can't take both. Total up your itemized deductions and look at them next to your standard deduction to determine whether or not itemizing will get you the most money back.
For example, if you paid $10,000 in interest on your first mortgage and $3,000 in interest on your home equity loan and you have no other itemized deductions, then your total adds up to $13,000. If you're filing jointly, the standard deduction of $25,900 is much higher, so it may not be in your best interest to itemize.
It's always a good idea to consult a tax professional to determine the best way forward. If you're on a budget, tax software can give you access to tax advice, consolidate your documents and maximize your deductions, but it may have a bit of a learning curve.
When interest on a home equity loan can't be deducted
Interest on a home equity loan isn't always tax deductible. You won't be able to write the interest off on your tax return for a home equity loan that goes over the IRS's limit or that wasn't used to acquire or improve a qualified residence.
Is there a tax break for home equity lines of credit (HELOCs)?
A home equity line of credit, or HELOC, is another type of second mortgage. With a HELOC, the amount you can borrow is based on the amount of equity you have in your home, which is equal to your home's appraisal value minus all loans secured by your home.
However, unlike with home equity loans, a HELOC is not a single payment. Rather, your lender creates an account, or line of credit, with the principal amount from which you can withdraw funds as needed.
Just like with home equity loans, the interest on a HELOC can be tax-deductible within IRS guidelines. The rules are the same for home equity loans and HELOCs. The loans must not exceed stated limits, and the funds must be used to buy, build or improve a qualified home.
Alternative ways for homeowners to save on taxes
If a home equity loan isn't right for you or if the interest on your loan doesn't meet the requirements to be tax-deductible, there are other ways to save on your taxes. These deductions may have caveats and exclusions, though, so you should definitely consult a tax professional if you have a special circumstance or are unsure whether or not you qualify.
Mortgage interest deduction
If you itemize, you can deduct the interest that you paid on your mortgage for your first or second home. The limits are the same as home equity loan tax deduction limits. If you're married filing jointly, interest on the first $750,000 of mortgage debt is deductible. If you're filing separately, the limit is $375,000. For mortgages that existed before December 15, 2017, these ceilings are $1 million and $500,000, respectively.
Your home must serve as collateral for the loan, and interest is only deductible on your first and second homes. A home can be a house, a condominium, a mobile home, a trailer, a boat or a similar property that has sleeping, cooking and toilet facilities. You can learn more about the mortgage interest deduction on the IRS's website.
Home office deduction
If you use part of your home for business, you may be able to deduct related expenses. Generally speaking, in order to qualify for this deduction, a portion of your home must meet two basic requirements:
1. You use it regularly and exclusively for business purposes
2. It is the principal place of your business
In other words, you must regularly use part of your home (or a separate structure on your property, such as a detached garage) exclusively for doing business, and you must show that you use your home as your principal place of business.
However, your home doesn't have to be your sole place of business. For example, if you frequently have in-person meetings with clients in an extra room in your house but also carry out business in another location, you can still deduct your expenses for that part of the home. This deduction is available to both homeowners and renters. Unfortunately, if you are an employee working from home rather than a business owner, you likely won't qualify for the home office tax deduction.
The IRS offers a simplified way to calculate and claim the home office tax deduction. For the 2022 tax year, the prescribed rate is $5 per square foot with a maximum of 300 square feet. For example, if your home office is 100 square feet, you would multiply that number by $5 per square foot for a deduction of $500.
Capital gains tax on a sold home
If you sold your primary residence during the tax year and received a capital gain, you may be able to exclude up to $250,000 of it from your income as a single filer or up to $500,000 of it as a married couple.
You qualify if you meet the IRS's ownership and have owned and used the house as your main home for at least two out of the five years leading up to the sale. You're ineligible if you've exercised this exclusion following the sale of another home within the past two years.
Which tax deduction is better: a home equity loan or HELOC?
Because the IRS's parameters are the same for home equity loans and HELOCs, neither tax deduction is better than the other. Choosing the right source of home equity funds depends on your unique situation — what kind of interest rate you're looking for, whether you need all of the cash at once and how much repayment flexibility you want. As a borrower, be sure to shop around and ask questions to ensure that you're getting the right product for your needs.
Should you get a home equity loan if it isn't tax deductible?
Again, this depends on your specific situation. A home equity loan or HELOC can be a good option if you need funds to make home improvements, pay for large expenses like education or consolidate high-interest debt like credit card debt.
Remember that home equity loans are tax-deductible within a certain limit and only when you use them to acquire a home or make substantial home improvements. Before taking out a home equity loan, make sure that you know the risks and understand the terms and conditions. And as with any tax consideration, its best to consult with a professional when determining how to prepare your tax return.
Summary of Are Home Equity Loans Tax Deductible
While interest from a home equity loan is tax-deductible, there are specific limitations and caveats to that rule. As per IRS rules, to enjoy the deduction, loans taken out after the passage of the TCJA must have been used to purchase or build a home, or improve one substantially. To get the mortgage interest deduction, you’ll also have to itemize your deductions, but this may not make the best financial sense — so make sure whether it’ll save you money.