Are home equity loans tax-deductible?

One of the big advantages of home equity loans over other types of financing is that their interest can be tax-deductible. But only under certain circumstances. The amount you can deduct depends on when you took out your loan and, more importantly, how you plan to use the funds.

Is the interest on home equity loans tax deductible?

Strictly speaking, only the interest on a home equity loan is tax-deductible, not the loan principal itself. 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, what you used the funds for and whether it makes more sense to itemize or take the standard deduction.

What are the rules and limitations of home equity tax deductions?

Until six years ago, you could take out a home equity loan, use it for almost anything, and fully deduct the annual interest you paid on your tax return. With the passage of the Tax Cuts and Jobs Act of 2017, all that changed.

First of all, it limited the use of the funds. For the interest to be tax-deductible, the money must be used to “buy, build or substantially improve” the primary or secondary home that was used to secure the loan. This means that you can no longer deduct the interest on home equity loans that you use to pay off debts, cover an emergency expense, or start a new business – anything that’s not home-related, in short.

Second, it limited the amount of interest you could deduct. Going forward, 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 and singles can deduct the interest on up to $375,000. 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 and singles.

Those limits also include any mortgage loans currently outstanding. For example, if you still have a mortgage balance of $500,000, only $250,000 of home equity loan debt will be eligible for a tax deduction.

Home equity loan deductions

Let’s say in 2022 you took out a home equity loan of $200,000. Half of that loan went toward paying off outstanding credit card balances, 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 the credit card debt would not be.

There’s another condition to taking home equity loan interest. Taxpayers must itemize their deductions (as opposed to taking the standard deduction) on their tax returns.

Are HELOCs also tax-deductible?

There are fairly strict parameters around when home equity lines of credit (HELOCs) are tax-deductible. Again, in order to qualify, you must buy, build, or substantially improve the home you used to secure the loan to deduct the interest.

Some types of expenditure make your HELOC interest non-deductible. These include paying off student loans, paying college tuition bills, or consolidating credit card debt.

You can deduct the interest if you’re using the HELOC to buy a second or vacation home, but this home must be the collateral for the debt. In other words, you can’t deduct the interest if you open a HELOC on your primary residence and then use the money to acquire or fix up a new beach house. The same applies for the home equity loan.

How to claim a home equity loan interest deduction

1. Know where you stand with both mortgages

The loan you originally 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 amounts of your mortgage and home equity loan on your most recent billing statements or by calling your loan servicer.

Next, confirm 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
• Extensively remodeling a kitchen
• Resurfacing a driveway

2. Gather your documents

To deduct home equity loan interest on your tax return, 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. These documents include costs for materials, labor and permits needed for the renovation or repair.

3. 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 appropriate tax year. You can either take the standard deduction or itemize deductions — but not both.

Greatly enhanced by the Tax Cuts and Jobs Act, the standard deduction amounts to:

Total your itemized expenses, including your home equity loan interest, and compare them to your standard deduction. Then, you can 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 2022. 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 $25,900, it doesn’t make sense to itemize just so you can deduct the interest you paid.

If you do end up taking the home equity loan interest deduction, it would be claimed on IRS tax form Schedule A, Itemized Deductions.

Bottom line on home equity loan tax deductions

The interest on a home equity loan is tax-deductible, provided the funds were used to buy or build a home, or make improvements to one, as defined by the IRS. However, if the combined interest on your first mortgage and home equity loan, plus any other itemized deductions such as state and local taxes, is less than the standard deduction for the tax year, it’s better to take the higher standard deduction instead of itemizing.

As with any tax consideration, consult with a professional when deciding how to prepare your return.

Even without the tax deduction, it still can be a savvy financial move to take out a home equity line of credit or home equity loan. Because they’re secured (that is, backed) by your home, these forms of financing tend to offer lower interest rates than credit cards or personal loans. Using home equity loans or HELOCs to eliminate more expensive, higher-interest-rate debt can be a smart investment, as it’ll free up your funds for savings or investing.