Many homeowners took advantage of lockdown measures in 2020 by tackling home renovation projects; and homeowners who used home equity loans to finance those projects may be wondering how that choice will affect their taxes. In short, the interest paid on home equity loans is tax deductible, but there are limitations.
Is interest on my home equity loan tax deductible?
Whether or not you can deduct the interest paid on your home equity loan depends on when you took out your loan, how much you borrowed and what you used the funds for.
With the passage of the Tax Cuts and Jobs Act of 2017, joint filers who took out their home equity loan after Dec. 15, 2017, can deduct interest on up to $750,000 worth of qualified loans, while separate filers can deduct the interest on up to $375,000. However, you’ll also need to use the loan funds to “buy, build or substantially improve” the home that secures the loan. This means that you can no longer deduct the interest on home equity loans that you use to pay off debt or put toward an emergency expense.
Keep in mind that those limits also include any mortgage loans currently outstanding; so if you still have a mortgage balance of $500,000, only $250,000 of home equity loans will be eligible for tax deductions.
If you took out your home equity loan prior to Dec. 15, 2017, your limits are higher at $1 million for joint filers and $500,000 for separate filers, as long as the funds were used to buy, build or improve the home.
Let’s say you took out a home equity loan in 2020 worth $200,000. Half of that loan went toward credit card debt consolidation, while the other half went toward the construction of a new home office. In this scenario, any interest you paid on the $100,000 used for your home renovation would be tax deductible, but the interest you paid on the $100,000 used for debt consolidation would not be.
How to get started
If you have a home equity loan, here’s how to tell whether you can deduct the interest.
Check details about both mortgages
The loan you first took out to buy the home is your first mortgage, and the home equity loan is your second mortgage. Both mortgages must fit IRS requirements. Combined, the debt must:
- Not exceed $750,000 or $1 million, depending on when the loans were taken out.
- Be secured by a “qualified residence,” which can be your main home or second home.
- Not exceed the value of the residence(s).
- Be used to acquire or substantially improve the residence(s).
You can find the dollar amount of your mortgage and home equity loan on your most recent billing statements or by calling your loan servicer.
What was the loan used for?
Next, check whether the home equity loan was used to buy, build or improve your home. Here’s a rule of thumb: A “substantial” improvement is one that adds value to the home, prolongs its useful life or adapts a home to new use. While the IRS doesn’t offer a full catalog of expenses that fit this description, here are a few examples:
- Building an addition to the home.
- Installing a new roof.
- Replacing an HVAC system.
- Completing an extensive kitchen remodeling project.
- Resurfacing the driveway.
Itemize your deductions
To take advantage of this tax break, you’ll need to itemize your deductions at tax time. That’s only worth doing if all of your deductions add up to more than the amount of the standard deduction for the 2020 tax year:
- $24,800 for married couples filing jointly.
- $12,400 for single filers or married people filing separately.
- $18,650 for head of household.
You can either take the standard deduction or itemize — not both. 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.
For instance, say you paid $2,600 in interest on a home equity loan and $9,100 in interest on your mortgage in 2020. You’re filing a joint return, and these are the only deductions you can itemize for a combined value of $11,700. Because $11,700 is far lower than the standard deduction of $24,800, it doesn’t make sense to itemize just so you can deduct the interest you paid. However, it’s always wise to speak to a tax professional to explore your options before proceeding.
Nearly 90 percent of taxpayers were projected to take the standard deduction when filing their 2018 taxes, according to a report by policy research organization the Tax Foundation. But if you end up taking the home equity loan interest deduction, it would be claimed on IRS tax form Schedule A, Itemized Deductions.
Gather your documents
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.