A home equity loan lets you use your equity for any purchase. Some investors use this money to fund another down payment, while others use it to cover living expenses. Homeowners can write off interest on a traditional mortgage, but what about a HELOC? We’ll discuss the required parameters for turning HELOC interest payments into tax deductions.
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The Basics of Mortgage Interest Deduction
Mortgages help you buy a home, but lenders will set an interest rate to earn a return on their capital. Although mortgage payments are not tax-deductible, you can deduct interest payments. For example, if you pay $1,700 per month to the principal and $300 per month for interest, you can deduct the $300/mo interest payments. You can deduct interest payments for any loan that uses your primary residence or second home as collateral.
Current Rules for Home Equity Loan Tax Deductions
We have already discussed using your home as collateral to qualify for a HELOC tax deduction. However, the IRS has other rules in place to qualify interest payments as deductibles. How you use the proceeds impacts your ability to deduct taxes. You must use the loan amount to buy, build, or improve a home. If you tap into home equity for a vacation or another personal reason, you can’t write off the interest payments.
The IRS also has caps for HELOC interest deductions. Married homeowners filing taxes together can deduct interest paid towards up to $750,000 for a mortgage. However, if you have a $1 million mortgage for your home, interest payments on the final $250,000 of that mortgage aren’t tax-deductible. You also won’t get a $750,000 tax-deductible since you can’t deduct payments towards the principal.
When is a Home Equity Loan Interest Tax Deductible?
Homeowners naturally have questions about their specific scenario. We’ll cover some ways to get an interest tax-deductible on your HELOC loan.
First or Second Home
HELOCs get the same treatment regardless of whether you pull the equity from your first or second home. Some investors use the money from a HELOC to afford the down payment for a second home. This strategy provides you with deductible interest payments and can protect you from private mortgage insurance premiums. If you don’t feel comfortable borrowing against your primary residence, you can borrow against your other properties or get money from Unlock. Unlock buys a stake in your home instead of giving you a loan. This strategy helps you avoid incurring debt by tapping into your home’s equity.
The way you use the loan impacts its eligibility. If you’re not investing in properties (buy, build, or improve), the interest payments are not tax-deductible. The IRS will also expect you to use a primary or second home as collateral. HELOCs used for personal expenses don’t qualify for interest tax deductions.
Using a home equity line of credit to improve your home can make the interest tax-deductible. The IRS only lets you deduct taxes on “substantial” improvements. You should demonstrate that your home improvement accomplishes at least one of the following:
- Increases your home’s longevity
- Increases your home’s value
- Adapts the home for added functionality
Homeowners can turn HELOC interest payments into tax deductions for many home improvements. Kitchen upgrades, outdoor spaces, bathroom modifications, and home offices are some of the many home improvements that trim your taxable income.
Arm’s Length Standard
The IRS wants to make sure borrowers pay back their loans and reduce the risk of foul play. The IRS wants to make sure all loans abide by the Arm’s Length Standard. If neither party knows each other before discussing the loan, it’s an arm’s length transaction. Non-arm’s length transaction occurs between family members or people who know each other well. One party member may try to use their relationship to manipulate the other person into a sour deal. HELOCs must abide by the arm’s length standard to qualify for interest tax deductions.
Homeowners take out construction loans to build new properties. Some homeowners opt for a HELOC instead of approaching lenders about construction loans. It’s easier to qualify for a HELOC, and you can continuously tap into that funding source. In addition, using HELOC proceeds to build a home or add to an existing home makes the interest tax-deductible.
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How to Claim a Home Equity Loan Interest Deduction
If you’ve made it to this point and feel confident that your HELOC interest qualifies for a tax deduction, the next step is claiming it in your returns. We’ll walk you through the process of using interest payments to lower your taxable income.
A lender will report your mortgage payment history on a 1098 Form. This payment history includes HELOCs and interest. Lenders file separate forms for each of your mortgages, and they’re only required to file if you pay more than $600 in interest, points, or mortgage insurance premiums.
Lenders give you a closing disclosure after you agree on a loan. This disclosure contains information on the loan’s monthly payment plan, term length, closing costs, and other details. Bring this document with you when meeting with your accountant. Some expenses listed in the disclosure, such as closing costs, qualify for tax deductions.
When applying for and obtaining a loan, you will get charged an origination fee. The IRS classifies origination fees as points, and you can deduct them from your taxes. You can deduct interest rates from your HELOC if you use it to buy, build, or improve a home, but don’t overlook other costs. You might qualify for additional tax deductions after paying all loan fees.
Home Improvement Expenses
Homeowners should document how they use the HELOC proceeds. If you renovate the kitchen, detail the cost of materials, services, and other expenses for the renovation. The more costs you list, the more you will save in taxes.
Are There Any Limits When Deducting Home Equity Loan Interest?
Deducting any amount of interest will lower your tax bill. However, the IRS has several limits that cap how much you can save with this strategy.
- Dollar Amount: You can only save on interest payments towards the first $750,000 of the debt. If you owe $800,000, you can’t write off the interest payments on the final $50,000.
- Itemizing Deductions: Taxpayers can only benefit from HELOC interest deductions if they itemize the expense. You should only itemize deductions and present them to the IRS if they exceed the standard deduction. The standard deduction is $12,550 for single or married filing separately, $18,800 for a head of household, and $25,100 for married filing jointly.
- Deduction vs. Credit: Deductions and credits lower your tax bill, but credits provide more savings. Deductions reduce your taxable income. If you have a $1,000 deductible, you will not save $1,000 on your taxes. You’ll reduce taxable income by $1,000 and pay a lower percentage of your money to the government. Tax credits reduce the bottom line you get after factoring in all deductibles. A $1,000 credit will lower your taxes by $1,000.
How to Access Home Equity Without Taking a Loan
Many homeowners use loans to buy homes, make improvements, and fund high-ticket expenses. While loans have their advantages, you end up with massive debt. When you borrow money against your home, it becomes collateral. The bank can take your house and trigger a foreclosure if you miss enough loan payments. Some homeowners need funds, but they don’t want to take on additional debt.
Unlock lets you tap into your home’s equity without incurring debt. Unlock buys stakes in homes instead of providing loans. You’ll receive cash upfront without any debt. Unlock makes money after you sell your home, leaving you without any debt. Unlock will provide you with cash even if you have low credit and significant debt. You can visit Unlock’s website and use their free home equity calculator to discover how much cash Unlock will give for a stake in your home.