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 home equity line of credit 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. Interest paid on either loan, like the interest on your first mortgage, is sometimes tax-deductible.
- Interest on a HELOC or a home equity loan is 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 whose 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 lines of credit.
- 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 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 whose equity is the source of the loan. If you meet the conditions, 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 only on up to $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 to cover college costs, for example.
However, interest on home equity money you borrow after 2017 is only tax-deductible for buying, building, or improving properties. This law applies between 2018 and the end of 2025. Given how complicated it all is, check your particular situation carefully with a tax expert before deducting anything.
In general, it is only worthwhile to use the tax deduction for larger home improvement projects, such as a new room or a remodeling of the entire house. Also, 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.
Like a credit card, the interest rate on a HELOC is variable and applies to the full outstanding balance.
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 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 combined loan-to-value ratio for a HELOC can exceed 80% for borrowers with strong credit ratings. If you select one of these loans, 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 you might lose your job. If you wait until after a job loss, 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.