Similar to home equity loans, home equity lines of credit (HELOCs) act as second mortgages and allow you to access cash by pulling equity out of your home. Maybe you’ve heard about tax benefits that come with HELOCs but aren’t sure how they work. This guide dives into the ways in which you can use the funds from a HELOC to get a break at tax time and where to find a reputable lender who offers this debt product.
What are HELOCs?
Before diving into tax deductions, it’s vital to understand how HELOCs work. They are revolving lines of credit that are typically tied to a variable interest rate, meaning the rate fluctuates over time based on market conditions. The big advantage of a HELOC compared to other financing options is the flexibility it provides.
You’ll only pay interest on the amounts you actually withdraw rather than an entire lump sum upfront. This makes HELOCs ideal for funding large one-time purchases or covering unexpected costs without taking on more debt than necessary.
In Which Case Is the Interest of a HELOC Tax Deductible?
You can deduct the interest paid on a home equity line of credit (HELOC) if the funds you borrow are used to make improvements or upgrades that significantly improve the home’s value. However, the property must also be used as security for the HELOC.
Rules for HELOC Interest Tax Deductions
To qualify for the HELOC interest deduction, you must meet the following eligibility criteria:
- Have a home mortgage that you secured after October 13, 1987
- Use the property as your main home or second home – the latter only qualifies if you occupy it for more than 14 days or use it as a rental and live there for more than 10 percent of the time it’s rented out
- Owe no more than $750,000 (or $375,000 if you’re married filing separately) on your home loan; this amount increases to no more than $1 million (or $500,000 if married filing separately) if the home loan was acquired before December 15, 2017
How Much HELOC Interest is Tax Deductible?
The HELOC interest deduction only makes sense if you itemize deductions on your 1040 and the total amount exceeds the standard deduction. Below are the standard deduction amounts for the 2023 tax year listed by filing status:
- Single or married filing separately: $13,850
- Head of household: $20,800
- Married filing jointly (married couples): $27,700
To illustrate, assume you paid $8,500 in interest on your first mortgage and $1,500 on your HELOC. Regardless of your filing status, you’d be better off taking the standard deduction since the total interest paid is only $10,000. However, if your filing status is single or married, you are filing separately, and your interest payments on your primary mortgage and HELOC were $10,000 and $3,500, itemizing deductions would be more sensible since this amount exceeds the standard deduction.
Remember, interest is only deductible on up to $750,000 of home loan balances ($375,000 for taxpayers who are married filing separately) or $1 million ($500,000 for taxpayers who are married filing separately) for homes purchased prior to December 15, 2017.
Limitations for HELOC Interest Tax Deductions
Installing a new HVAC system, renovating your bathroom, adding an additional bedroom or upgrading your kitchen would all be deemed qualifying improvements. However, paying off credit card debt, covering medical expenses, or taking a luxurious vacation wouldn’t qualify as expenses per the IRS, and the interest on the HELOC wouldn’t be tax deductible.
Also, be mindful that the home renovations must be made on the property the HELOC uses as security to qualify for the HELOC interest tax deduction. This means you can’t take out a HELOC on your primary residence and use it to renovate a property that is only used as a rental in another state.
It’s also important to note that if you use HELOC funds for qualifying home improvements, the interest deduction only applies to the extent those funds were actually used to improve the property. For example, if you took out a $50,000 HELOC and spent $30,000 on renovations, only 30/50 or 60 percent of the total interest paid that year would be deductible. Furthermore, if you later use the remaining HELOC balance for non-qualifying purposes like vacations or credit card payments, you would lose the deduction for all interest paid going forward.
Documentation Needed to Claim Your HELOC Interest Tax Deductions
Form 1098: Mortgage Interest Statement
You should get a copy of “Form 1098: Mortgage Interest Statement” in the mail from your lenders by January 31st for the previous tax year. Look for the amount of interest you paid on your primary mortgage and HELOC, and include these amounts on “Schedule A: Itemized Deductions” when filing your return.
Be sure to keep copies of your 1098 forms just in case the IRS decides to audit you in the future. It’s equally important to retain receipts for any purchases you make using the funds to provide proof of how the money was spent.
Copy of Your Closing Disclosure and HELOC Loan Application
These documents should also be kept in a safe place just in case you need to reference them at tax time. You can store them in a file cabinet or vault and keep electronic copies to ensure you can access these documents if needed. And if you’re audited, the IRS will also want to take a look.
Process of Claiming Home Equity Loan Interest Tax Deduction
As mentioned above, home equity loan interest may be tax deductible under certain conditions. If you want to claim this deduction, you’ll need to itemize your deductions and meet specific criteria. Here’s a step-by-step breakdown for claiming this tax deduction.
Steps to Claim Your Tax Deduction
- Step 1: Determine if your loan qualifies for a tax deduction. To be eligible for a deduction, the loan must be secured by your main home or a second home. The home should have sleeping, cooking and toilet facilities. The loan must also be taken out for the purpose of buying, building, or substantially improving your home.
- Step 2: Understand the implications of the Tax Cuts and Jobs Act. As of December 16, 2017, the Tax Cuts and Jobs Act introduced specific changes for home equity loan interest deductions. The rules allow for interest deductions on mortgage debt up to $750,000 (or $375,000 if you’re married, filing separately). In case your loan exceeds these limits, the interest paid on the excess amount won’t be deductible.
- Step 3: Itemize your deductions. To claim the home equity loan interest tax deduction, you must itemize your deductions on your tax return instead of taking the standard deduction. So, evaluate whether itemizing your deductions will give you a higher deduction than the standard deduction.
- Step 4: Fill out the appropriate tax forms. After determining that you’re eligible for the home equity loan interest deduction, be sure to fill out Schedule A on your tax return. You’ll report the interest paid on the home equity loan or line of credit on this form. Make sure to get a copy of Form 1098 from your lender, which will show the amount of interest paid during the tax year.
By following these steps, you can make the most of your home equity loan interest tax deduction. Be attentive to the eligibility criteria and tax implications, and consult a tax professional if necessary to ensure you’re maximizing your tax savings.
Common Misconceptions about Home Equity Loans and Tax Deductions
Many people believe that home equity loan interest is always tax deductible. However, this is not always the case. The Tax Cuts and Jobs Act significantly changed the rules surrounding tax deductions for home equity loan interest.
According to the new rules, you can only deduct interest on home equity loans if the funds are used to buy, build or substantially improve the property securing the loan. So, if you use the funds for personal expenses, such as paying off credit card debt or financing a vacation, the interest is not tax deductible.
Another misconception is that there is no limit to the amount of deductible home equity loan interest. In fact, there is a cap on the amount of mortgage interest you can deduct. For tax years 2018 to 2025, the cap is $750,000 for joint filers, which includes your existing mortgage balance, one vacation or second home, and any deductible home equity loan interest.
It is also essential to remember that to take advantage of home equity loan interest tax deductions, you must itemize your deductions on your tax return using IRS Form 1040 rather than taking the standard deduction.
Where Can You Get a HELOC?
Several banks, credit unions and other financial institutions offer HELOCs nationwide. But with so many options to choose from, finding the perfect fit can be overwhelming. Ultimately, you want to find a lender that’s reputable and will put you first.
Large banks have the scale and resources to handle HELOCs efficiently, but they may not offer the most personalized service. That said, many of them have recently discontinued this product line until further notice.
Regional and community banks or credit unions may be better options if you value local customer service over national availability. These smaller financial institutions tend to have fewer borrowers, so loan officers have more time to discuss your specific needs and goals. They can also be more flexible with underwriting guidelines. However, not all physical branches are everywhere.
You’ll also want to research whether independent mortgage companies in your area offer HELOCs. You can also explore options with online lenders. While they won’t have physical branch locations, many have online application processes. They tend to be smaller than big banks but larger than local credit unions. Rates may be competitive, and application turn times could be faster than going through a large national bank. Just be sure to thoroughly vet any lender you aren’t familiar with.
Conclusion: Is The Interest on a Home Equity Loan or a HELOC Tax Deductible?
If you use the proceeds from a home equity loan or HELOC for home improvements, the interest you pay on the loan is generally tax deductible. To deduct this interest, you need to itemize deductions on your tax return using IRS Form 1040.
Keep in mind that there are conditions you need to meet in order to claim this deduction. The funds must be used for buying, building, or substantially improving your home. And if the home equity loan or HELOC was taken out after Dec. 15, 2017, you can only deduct interest on up to $750,000 worth of qualified loans (or $375,000 if married filing separately).
Consult with a reputable accountant or tax advisor to learn more or determine if it makes sense to take this deduction.
