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If you need cash and have equity in your home, a home equity loan or home equity line of credit (HELOC) can be an excellent solution. But the tax aspects of either option are more complicated than they used to be. Interest on a HELOC may be tax deductible—but there are conditions.
There are two types of home equity lending: a fixed-rate loan for a specified amount of money, or a variable-rate line of credit (HELOC). Depending on your need for the funds and how you plan to use them, one option may work better than the other. Interest paid on either loan, like the interest on your first mortgage, is sometimes tax deductible.
Key Takeaways
- Interest on a home equity line of credit (HELOC) or a home equity loan is tax deductible if you use the funds for renovations to your home—the phrase is “buy, build, or substantially improve.”
- To be deductible, the money must be spent on the property in which the equity is the source of the loan.
- Taxpayers can only deduct interest on up to $750,000 of residential loans (up to $375,000 for a married taxpayer filing a separate return), which includes all residential debt—mortgages as well as home equity loans or HELOCs.
- Older mortgages may be covered under the previous $1 million limit (or $500,000 for a married taxpayer filing a separate return).
New Rules for Home Equity Tax Deductions
Since the tax law changed in 2017, the tax deductibility of interest on a HELOC or a home equity loan depends on how you are spending the loan funds. That applies to interest on loans that existed before the new tax legislation, as well as on new loans. Here’s how it works.
Interest on home equity debt is tax deductible if you use the funds for renovations to your home—the phrase is “buy, build, or substantially improve.” What’s more, you must spend the money on the property in which the equity is the source of the loan. If you meet the conditions, then interest is deductible on a loan of up to $750,000 ($375,000 or more for a married taxpayer filing a separate return).
Note that $750,000 is the total new limit for deductions on all residential debt. If you have a mortgage and home equity debt, what you owe on the mortgage will also come under the $750,000 limit—if it’s a new mortgage. Older mortgages (before 2018) may be covered under the previous $1 million limit (or $500,000 for a married taxpayer filing a separate return).
That gives people borrowing for renovations more benefits than before. Previously, interest was deductible on up to only $100,000 of home equity debt. However, you got that deduction no matter how you used the loan—to pay off credit card debt or cover college costs, for example.
However, interest on home equity money that you borrow after 2017 is only tax deductible for buying, building, or improving properties. This law applies from 2018 until 2026. Given how complicated it all is, check your particular situation carefully with a tax expert before deducting anything.
Be aware that the 2017 tax reforms increased the standard deduction to the point that it no longer makes sense for many people to itemize tax deductions, making the HELOC and home equity loan interest deduction obsolete. The standard deduction in 2022 is $12,950 for single filers and $25,900 for married filing jointly.
Unless you have an exceptionally large HELOC or home equity loan, the interest paid on it is unlikely to be the deciding factor in taking the standard deduction or itemizing deductions, especially with historically low interest rates. If you are already itemizing your deductions, then choosing a HELOC or a home equity loan over something like a personal loan so that you can deduct the interest may make the most financial sense for you.
Like a credit card, the interest rate on a HELOC is variable and applies to the full outstanding balance.
How to Claim the Home Equity Interest Deduction
If you own a home and are planning to claim the home equity loan interest deduction, there are a few things to remember.
First, the money must be used for home improvements or renovations. For example, you cannot take the deduction if you are using home equity proceeds to pay for personal expenditures or consolidate credit card debt. The same goes if you are taking out a loan and letting the money sit in the bank as your emergency fund.
What’s more, the renovations have to be made on the property on which you are taking out the home equity loan. You cannot, for example, take out a loan on your primary residence and use the money to renovate your cottage at the lake.
Next, keep proper records of your expenses. The odds of being audited by the Internal Revenue Service (IRS) are generally low, but you do not want to take any chances. If you plan to use a home equity loan or a HELOC to pay for home repairs or upgrades, be sure to keep receipts for everything you spend and bank statements showing where the money went.
Finally, remember that this deduction is not unlimited. You can deduct the interest on up to $750,000 in home loan debts, if the loans were made after Dec. 15, 2017. If your total mortgage debt is higher than that, then you won’t be able to deduct all of the combined interest paid. The $1 million cap applies for mortgages obtained before that date.
As interest on older mortgages retains a legacy to $1 million loans, check carefully with your accountant about what you can deduct if you have both an older mortgage and a home equity loan that qualifies for deductions.
Harder to get a HELOC or Home Equity Loan in 2021
At the beginning of the coronavirus pandemic, both Wells Fargo and JPMorgan Chase stopped accepting HELOC and home equity loan applications, citing market conditions.This reflects an overall market trend away from home equity loans and HELOCs and toward refinances, making it harder for consumers to get HELOCs or home equity loans.
Other Benefits of a HELOC
HELOC rates (and home equity loan rates) are only slightly higher than first mortgage rates, making HELOCs much less expensive than other loan options. Taking a HELOC also means that you only borrow as much as you need—not a lump sum, as is the case with a home equity loan. Sometimes, a HELOC features an option to lock in a fixed interest rate to repay the outstanding balance.
As a homeowner, you may borrow up to a specified amount based on the combined loan-to-value (CLTV) ratio. That includes the outstanding balance from a first mortgage plus the additional requested funds.
Generally, the CLTV ratio for a HELOC can exceed 80% for borrowers with strong credit ratings. If you select one of these loans, then any interest on a balance that exceeds the home’s value is not tax deductible. Higher-LTV loans charge bigger fees and put you at greater risk of going underwater on your loans should real estate values drop.
Getting a HELOC when one is available also makes more cash accessible in an emergency. Interest on a HELOC only applies when homeowners use the money, so the cost of getting one is relatively low. Therefore, it can be a good move to get one if you think that you might lose your job. If you wait until after a job loss, then you might not have sufficiently good credit to get a HELOC. Furthermore, banks can raise credit standards for HELOCs when an economic downturn, such as the coronavirus recession, occurs.
Should I Get a Home Equity Line of credit (HELOC) or a Home Equity Loan for the Tax Deduction?
If you need a large amount of cash specifically to fund an improvement or repair on your primary residence, and if you are already itemizing your deductions, then a home equity line of credit (HELOC) or a home equity loan is probably an economically sound choice. If you are on the fence about a property remodel, then borrowing against your home just to take advantage of deducting the interest is probably not the best choice for you.
Can I Get a HELOC or a Home Equity Loan Without a Tax Return?
Documentation requirements will vary based on the lender that you use and your personal situation. While it is possible to get a HELOC or a home equity loan without showing your tax return, pay stubs, and so on, it is usually more expensive. Low- or no-documentation loans are very risky and were mostly banned with the passage of the Dodd-Frank Act of 2010, as they directly contributed to the mortgage crisis. Finding a HELOC or home equity loan lender that will approve your loan with no documentation may be tricky and put you at risk of becoming a victim of a lending scam.
What Expenses Count?
While the Internal Revenue Service (IRS) did not include a list of expenses that would be covered under the law’s provisions, their advice did include some examples of allowable home improvement expenses, such as building an addition to your home. Other purposes that qualify for the deduction if you’re using a home equity loan or a HELOC include:
- Putting a new roof on the property
- Replacing your HVAC system
- Completing an extensive kitchen or bathroom remodeling project
- Resurfacing your driveway
The Bottom Line
Taking out a home equity loan or a HELOC just to deduct the interest on your taxes was never the best decision, and tax changes make it even less practical. If you are already planning on taking out a HELOC or a home equity loan for repairs or improvements to your primary residence, keep your documentation handy so you can show it to your tax advisor and make an informed decision on whether itemizing your deductions is a good choice.
