Whether you're just getting started researching the best home equity loans or have already narrowed down a top list of home equity line of credit (HELOC) options, it's important to understand the tax implications of a HELOC before you sign on the dotted line. One of the top questions from those looking to utilize their home equity is whether HELOC interest is tax deductible. The answer to this question depends on a few factors, and in this article, we'll explore the requirements and limitations of HELOC tax deductions, how to calculate a HELOC interest tax deduction and some HELOC tax advantages and implications.
What is tax deductibility?
Tax deductibility refers to the process by which you can subtract certain expenses and investments from your taxable income. It is meant to provide people with an incentive to act in a way that is beneficial to both themselves and the broader economy. This is accomplished through various methods, including itemized deductions, tax credits, work-related deductions, education deductions, health care deductions, investment deductions and more.
Is interest on a HELOC tax deductible?
The main tax advantage of a HELOC is that you may be able to deduct the interest paid on the loan. The IRS allows you to deduct the interest paid on a home equity loan or HELOC if the funds are used to pay for qualified home improvement expenses, if it meets the requirements outlined in IRS publications 936 and 535 and if you file an itemized deduction.
The IRS requires the funds to be used to “buy, build, or substantially improve" your primary home or second home. The home equity loan or HELOC must be secured by either your home or second home as well. There are also limits on the amount of interest you can deduct, as outlined in IRS publication 936.
Requirements for a HELOC interest tax deduction
The IRS has set out certain requirements you have to meet to receive the deduction. The following sections will examine each of these requirements in greater detail.
Primary residence requirement
In order to take advantage of the deduction, your loan must be secured by a qualifying home. In most cases, the term “qualifying home” refers to a taxpayer’s main residence or second home. In order for a second home you're renting out to qualify, you must use it for at least 14 days each year or 10% of the number of days it’s rented out, whichever is greater.
Only one home can be treated as a second home in any tax year. You can change which home is treated as the second home within one tax year if one of the following circumstances applies:
- If you purchase a new home, you can decide to immediately use it as your second home.
- If your main home no longer qualifies for tax purposes, you can immediately begin treating it as your second home.
- If you sell your main home and your previous second home becomes your main home, you can immediately designate a new second home.
Aside from these situations, there are a few other situations worth noting:
- A home under construction can act as a qualified home for up to 24 months if it becomes your primary residence when it's ready for occupancy.
- A home that has been destroyed can act as a qualified home for "a reasonable amount of time after" its destruction if you rebuild the home and move into it or sell the land on which the home was located.
- A home you own as part of a time-sharing arrangement can act as a qualified home if it meets all of the base qualified home requirements.
Maintaining accurate records of HELOC transactions
It's extremely important to keep records of all transactions related to your HELOC, including the payments you've made and the interest your HELOC accrued, as well as receipts and invoices documenting your home improvement costs. This will likely include receipts for materials, labor costs, and any other expenses related to the renovations, repairs or improvements. Keeping detailed records of bank statements will go a long way toward helping you prove your deductions if the IRS ever questions them.
Meeting IRS requirements
In order to be sure you’re meeting all requirements for deducting interest on your home equity loan or line of credit, it's important to read through the IRS’s Publication 936, Home Mortgage Interest Deduction. This publication provides a detailed overview of what types of interest are deductible, what homes qualify and how to accurately report the deductions on your tax return. By carefully following all of the guidelines set forth by the IRS, you can maximize your deduction for your home equity loan or line of credit and minimize the risk of surprises come tax time.
Limitations of tax deductions on HELOCs
Just as there are several requirements for deducting interest on your home equity loan or line of credit, there are also some notable limitations. These limitations range from what you can spend the money on to actual dollar limits on how much of the interest you can deduct.
Mortgage limitations for tax deductions
HELOC interest is deductible for up to $750,000 of indebtedness ($375,000 if married filing separately). For loans and mortgages taken out prior to December 16, 2017, the limit is $1 million ($500,000 if married filing separately). Tax code changes altering the deduction limit are set to expire in 2026 and will revert back to the $1 million limit if not extended or otherwise updated.
Usage of HELOC funds
The funds you receive from your loan or line of credit must be used for “substantial improvements” or construction of your home for any interest to be tax deductible. These improvements can range from simple repairs to large-scale remodeling projects, but the key is that these improvements must add value or increase the home’s livability. Funds used for other purposes, such as paying off debt or educational expenses, are not tax deductible.
Alternative Minimum Tax (AMT)
The alternative minimum tax (AMT) is a specific form of federal income tax that applies to certain high-income individuals. This alternative taxation structure is meant to ensure that individuals with a certain level of income are paying at least a minimum amount of taxes and can’t take advantage of too many deductions.
Before the Tax Cuts and Jobs Act (TCJA) was passed and enacted in late 2017, taxpayers who were subject to the AMT were able to deduct interest on up to $100,000 of indebtedness ($50,000 if married filing separately) for home equity loans and HELOCs if the funds were used to build or substantially improve a qualifying home. However, the TCJA eliminated all deductions related to home equity loans and HELOCs for individuals paying the AMT.
How to calculate a HELOC interest tax deduction
There are a few important steps to calculating your HELOC interest tax deduction and ensuring that you are taking full advantage of this HELOC tax benefit.
1. Gather your HELOC statements and other necessary documentation
The first step is to gather all the necessary documents and information. This includes your HELOC statements, tax forms and any other documentation related to the HELOC. Your HELOC statements will help prove how much you've borrowed as well as how much interest you've paid over the course of a given tax year.
2. Identify qualified expenses
Next, you need to identify any qualified expenses associated with the HELOC. The TCJA limits the deduction for interest on home equity loans and HELOCs to expenses associated with the purchase, construction or improvement of a qualified home. When it comes to home improvements and repairs, examples include replacing the roof, installing a new HVAC system, refinishing wood floors, landscaping, masonry work and more.
Each of these activities comes with a variety of costs, including labor and materials. It’s important to track these expenses carefully and keep a detailed record of all costs associated with your HELOC-funded projects. This means documenting the amount of money you spent on each activity as well as keeping any receipts and invoices. Bank statements will also help provide a detailed paper trail of all these transactions in case of an IRS audit.
3. Calculate your total mortgage interest paid
Once you've gathered all of the necessary documentation of your qualified HELOC-funded expenses and activities, it's time to calculate the total amount of interest you’ve paid on your loan. Your monthly HELOC statements will provide a detailed breakdown of the total interest paid over a given period. For example, if you took out a HELOC in June of 2020 and paid interest on it for the rest of the year, your statement will show the amount of interest paid for the entire year. Your lender should also send you a Form 1098 each year that outlines the amount of loan interest you paid for tax purposes.
4. Confirm the total deductible interest
Once you’ve calculated your total mortgage interest paid, it's important to verify the total deduction amount. Remember that HELOC interest is only tax-deductible for the first $750,000 of total qualifying indebtedness ($375,000 if married filing separately). This means the interest you paid on amounts beyond the first $750,000 is not tax-deductible. You’ll need to add up the total amount of HELOC interest paid for the tax year, subtract any non-deductible amounts and enter the total on your tax return.
5. When in doubt, consult with a tax professional
As with other serious tax-related matters, it’s always best to consult with a qualified tax professional if you're unsure about how to properly report your HELOC tax write-off. A professional will help ensure that you’re accurately reporting your HELOC interest tax deduction to the IRS, as well as provide advice on any other possible tax-saving strategies that could apply to your particular situation.
Other tax implications of HELOCs
Aside from the HELOC tax implications mentioned above, there are a few tax-related issues worth clarifying. First off, HELOCs aren't taxed as regular income, as they represent money loaned rather than earned. Second, some jurisdictions (a few states and smaller municipalities) impose a mortgage recording tax on home equity loans and HELOCs, which is typically a percentage of the total loan amount. Lastly, deducting interest payments for HELOCs will require you to take an itemized deduction instead of the standard deduction. In some cases, you may owe less in taxes by simply taking the standard deduction.
Does HELOC affect property taxes?
In most jurisdictions, only the appraised value of your home and the applicable local tax rate determine your property tax bill. As such, the amount of HELOC you take out won’t affect your property taxes. However, if you use proceeds from the HELOC to finance certain home improvements or upgrades that result in the appraised value of your home going up, then your property taxes could potentially increase. For example, if you use a HELOC to add a new pool or make other significant improvements to your property, the local assessor could take this into account when estimating the value of your home for tax purposes.
In some circumstances, interest on home equity loans and HELOCs is tax deductible. But there are several pros and cons of home equity lines of credit (HELOCs) that you should consider before taking one out, including their tax implications. Generally speaking, interest payments on HELOCs are deductible as long as the loan funds are used to purchase, build, or improve your primary residence or second home.
This deduction applies to interest payments on up to $750,000 of qualifying indebtedness ($375,000 if married filing separately). If you decide to take out a HELOC and deduct the interest payments, be sure to keep detailed records of how you use the loan proceeds and gather any documents related to the HELOC interest payments themselves. This will help you take full advantage of the available tax savings and can help you if the IRS ever questions your deductions.