A home equity loan is a loan where your home serves as collateral — a slightly risky move, but useful in certain circumstances. Additionally, you may be able to deduct the interest you pay on a home equity loan as long as you meet a few conditions. Taxpayers who list deductions on their returns, who spend proceeds from a home equity loan to buy, build, or substantially improve the property, and who do not have excessive mortgage debt overall, may qualify for this deduction.

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Home equity basics

Home equity loans use equity in the borrower’s home as collateral. Taking out a home loan therefore means putting the borrower’s home at risk. If the borrower cannot repay the loan, the lender can give notice and sell the home to pay off the debt.

Home equity loans generally have lower interest rates than other loans, such as B. unsecured personal loans, but may come with higher fees and other costs. And they’re only available to homeowners who have enough equity in their homes to meet lenders’ loan value (LTV) requirements. LTV benchmarks typically limit loans to 80% of the home’s appraised value.

Regular home equity loans grant the borrower a one-time cash payment. Home equity lines of credit (HELOCs) allow borrowers to take cash whenever they want, up to the amount of the loan. HELOC borrowers only pay interest on funds actually disbursed.

Mortgage interest deduction basics

Mortgage interest deductions allow homeowners who took out a loan to purchase their homes to deduct the interest paid during a year from that year’s taxable income. However, only homeowners who list deductions can claim that deduction. Many opt instead for the standard deduction, which for 2022 is $12,950 for single and married people filing separate applications, $25,900 for joint applicants, and $19,400 for heads of household.

The tax law also only allows mortgage interest deductions up to a mortgage debt of $750,000. A higher limit of $1 million applies to mortgages originated before December 16, 2017. The limit applies to the total mortgage debt of up to two homes.

Home loan interest deduction

The IRS rules for home equity loans are somewhat similar to original loans used to purchase the home, such as home equity loans. Interest deductions for home equity loans are capped at the same $750,000 of the total mortgage debt. And interest deductions on home equity loans can also only be claimed for qualifying residencies, which normally allows for a primary and secondary residence.

The big difference with home equity loan interest deductions is that they can only be claimed if the loan proceeds are used to purchase, build, or substantially improve the property.

If a borrower uses the loan for another purpose, such as paying off a high-interest credit card balance, the interest is not deductible.

Also, the loan must be secured by the home being bought, built or improved. If a borrower uses a home loan secured by a primary residence to purchase, build, or improve a vacation home, the interest is not deductible.

The tax regulations do not define exactly what constitutes a substantial improvement. In general, however, it is understood as a permanent improvement that increases the value of the home. Examples include:

• Adding a room, e.g. B. a bedroom, a bathroom or a study
• replacing a roof
• build swimming pool
• Upgrading or replacing a heating or cooling system
• Remodeling of the kitchen
• Installation of the windows

Less permanent improvements may not qualify. For example, repainting a room probably wouldn’t be deductible. Note that the borrower should be able to tie the proceeds of the home equity loan to a specific improvement and keep receipts to support the expense.

The $750,000 mortgage limit applies to all loans taken out on the home or homes. So a borrower with a home and vacation home who owes a total of $500,000 on the two homes could only deduct interest on a home equity loan of $250,000 or less. If a larger home equity loan is taken out, interest is only deductible on up to $750,000 of the loan.

Alternatives to home equity loans

Alternatives to a home equity loan may be preferable. For example, paying for improvements with an unsecured personal loan will not jeopardize your home ownership, although the interest on the personal loan is likely to be higher and also non-deductible. A cash-out refinance is another option. A homeowner doing a cash-out refinance takes out a new loan for more than the balance of the original mortgage and pockets what’s left over after paying off the original mortgage.

Interest paid on the refinance loan amount used to pay off the original mortgage is tax deductible as long as the taxpayer lists and does not owe more than $750,000 in total mortgages. After the original mortgage is paid off, other funds from a cash-out refinance, such as a home equity loan, are tax-deductible only to the extent that they are used to purchase, construct, or substantially improve a qualifying home that secures the loan.

bottom line

Interest on home equity loans may be deductible if the taxpayer lists a total mortgage debt of no more than $750,000 and uses the proceeds to purchase, build, or substantially improve the property. The improvements must be made to the property securing the loan. Other restrictions limit the interest deduction on mortgage loans to only up to $750,000 in total.

Financial planning tips

• A financial advisor can help you with home equity loans or other financial issues. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool puts you in touch with up to three financial advisors operating in your area and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
• To see what your income tax payment might look like, use SmartAsset’s free tax calculator.

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