Before taking out a home equity loan, it’s important to know whether a home equity loan tax deduction would apply for your situation. After the Tax Cuts and Jobs Act of 2017 was passed, federal tax laws changed the rules on home equity interest deductions, effective through 2026.
People who borrow against their home equity — the difference between how much the house is worth and any debts against the home — can still take advantage of the home equity loan interest deduction if they opt to itemize instead of taking the standard deduction and use the home equity funds to buy, build or renovate the home.
New limits on deductibility
The tax law says that borrowers must use the home equity money to “buy, build or substantially improve the taxpayer’s home that secures the loan” in order to deduct interest. If the renovation is purely cosmetic, you may not be able to. “Repairs that maintain your home in good condition, such as repainting your home, aren’t substantial improvements,” the IRS states.
Stephen B. Bacon of Connecticut-based Bacon and Gendreau Tax Preparation says, “Now people have to really track how that money is being used and show it to us.” He recommends saving receipts from contractors and others who make home improvements.
Borrowers who use home equity to buy a vacation home or invest in other real estate they’re not borrowing against won’t be able to deduct the interest paid against their taxable income.
The same goes for those who use home equity loans to consolidate student loans or high-interest credit card bills, or to pay for a wedding or vacation.
This is a big change from previous years, when home equity borrowers were allowed to deduct the interest even if they spent the loan on things that had nothing to do with their homes.
Home improvements and repairs are, by far, considered the best reason to borrow against home equity, according to a 2018 Bankrate survey.
Lower cap on home equity loan interest deduction
Home equity borrowers should also be aware of the fact that the Tax Cuts and Jobs Act lowered the cap on the amount of home loan debt that qualifies for the interest deduction from $1 million to $750,000. For homeowners who are married but filing separately, the limit is $375,000.
Interest on home loan debt above $750,000 is not deductible. The good news is that the $1 million limit — or $500,000 if married but filing separately — still applies to any mortgage taken out before Dec. 16, 2017.
The changes around home equity loan tax deductions won’t help homeowners who owe more on their mortgage than the home is worth, also known as being underwater.
Higher standard deductions
Higher standard deductions are another factor that will influence your tax strategy. For married couples filing jointly, the standard deduction is $24,400; for single filers and married couples filing separately, it’s $12,200. Head-of-household filers receive a standard deduction of $18,350.
After totaling your itemized expenses, including your home equity loan interest, and comparing them to your standard deduction, you have to decide whether itemizing is to your advantage.
Nearly 90 percent of taxpayers were projected to take the standard deduction when filing their 2018 taxes, according to the policy research organization the Tax Foundation.
If you end up taking the home equity loan interest deduction, it would be claimed on IRS tax form Schedule A, Itemized Deductions.
Should I deduct interest on my home equity loan?
The decision to claim the home equity loan tax deduction largely depends on your specific tax situation and whether your home equity loan qualifies for the deduction.
Bacon says that residence loans (i.e., home equity loans, HELOCs and mortgages) must meet three criteria for the interest to be deductible. The debt must:
- Be secured by a qualified residence(s).
- Not exceed the value of the residence(s).
- Be used to acquire or substantially improve the residence(s).
Loans that are secured by your main home or a second home qualify for the home equity loan interest deduction. These include a mortgage to buy your home, a second mortgage, a HELOC or a home equity loan.
Assuming your home equity loan meets dollar limits and qualifies for the deduction, you’ll need to calculate your total mortgage interest. If your itemized deductions, including the mortgage interest you paid, is higher than the standard deduction, the deduction may be worth claiming. However, it’s always wise to speak to a tax professional to explore your options before proceeding.
Documents you will need to deduct home equity loan interest
To deduct home equity loan interest on your tax return, you’ll need to gather the following documents:
- Mortgage Interest Statement (Form 1098). This form is provided by your home equity loan lender and shows the total amount of interest paid during the previous tax year.
- Statement for additional interest paid, if applicable. If you paid more home equity loan interest than what’s shown on your Form 1098, you’ll need to attach a statement to your tax return with the additional amount of interest paid and an explanation of the discrepancy.
- Proof of how home equity funds were used. Keep receipts and invoices for any expenses that significantly improve the value, longevity or adaptability of your home. This includes costs for materials, labor and permits needed for the improvement.
Other homeowner tax benefits
If you own your home, you may also be able to take advantage of other benefits, such as:
- Mortgage interest paid. As with the home equity loan interest deduction, you can deduct the interest you’ve paid on your first mortgage and refinanced mortgages.
- State and local real estate tax deduction. You can deduct property taxes up to $10,000 when filing jointly ($5,000 if you’re married but filing separately).
- Points. Points may be added to your home mortgage at an extra cost to you. You may be able to deduct some or all of the points for the tax year if you meet a battery of tests.
The bottom line
If you’re looking to claim the home equity loan interest deduction on your taxes, you must be aware of current tax requirements. Your loan is tax deductible only if it was used toward your home. If you have used the loan to buy a second home or renovate a home and you qualify for a tax deduction, figure out whether itemized deductions will be higher than the standard deduction.
Featured image by Thomas Barwick of Getty Images.