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Is Home Equity Loan Interest Tax Deductible?

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You can write off home equity loan interest as long you used the funds to renovate your home.

However, you’ll need to know how to document the expenses, which we’ll cover as we answer the question, “Is home equity loan interest tax deductible?”

Should I deduct interest on my home equity loan?

You should consider deducting the interest on your home equity loan if you used the cash to “buy, build or substantially renovate your home,” according to the IRS.  This may be a bit of a surprise if you took out a home equity loan after Dec. 15, 2017, when the Tax Cut and Jobs Act (TCJA) was passed.

Prior to the passage of the TCJA, you could deduct home equity loan interest even if it was used for other financial reasons, such as debt consolidation or to buy another asset. However, the new law limits home equity loan interest deductions to home-improvement-related expenses.

Rules on deducting home equity loan, HELOC or second mortgage interest

The home mortgage interest deduction allows you to deduct interest paid on your home equity loan in a given year. Under the current guidelines, taxpayers who took out a home equity loan after Dec. 15, 2017, can deduct:

  • The interest paid on up to $750,000 of their mortgage debt for married couples filing jointly if it was used to buy, build or improve their main home or second home
  • The interest paid on up to $375,000 of their mortgage debt for married couples filing separately if it was used to buy, build or improve their main home or second home

Under these rules, you could potentially deduct home equity loan interest up to the maximum limits if you:

  • Buy a primary residence or second home using a home equity loan
  • Build a primary residence or second home using a home equity loan
  • Make home improvements to your current primary residence or second home using a home equity loan
THINGS TO KNOW

Homebuyers will typically use a home equity loan to buy a home in one of the following scenarios:

  1. They’re taking out an 80-10-10 loan to avoid mortgage insurance.
  2. They’re buying a new home while they’re waiting for their current home to sell.

In the first scenario, you can avoid mortgage insurance if you take out the first mortgage to 80% and finance another 10% with a home equity loan. This is also called a “piggyback” loan. Mortgage insurance protects lenders against losses on mortgages they make to homebuyers with less than a 20% down payment.

In the second example, you can use the proceeds of the sale of your home to pay off the home equity loan balance, leaving you with just the payment on the first mortgage.

What you’ll need to claim the home equity loan interest deduction

  • Copy of the 1098 form. You should receive a form 1098 from your current loan servicer at the end of the year. The amount listed in Box 1 shows the amount of interest you paid.
  • Copy of your closing disclosure. You’ll receive a closing disclosure three business days prior to closing, which provides a breakdown of all the costs paid when your home was purchased.
  • Copy of your loan application. Also called a uniform residential loan application, have a copy handy as added proof that the home you purchased was a primary residence or second home.
  • Copies of home improvement expenses. Keep your invoice, receipts and work orders to prove you used your home equity loan funds for home improvements.

Other tax breaks for homeowners

Mortgage interest on your first mortgage. If you currently have a first mortgage, you may deduct the mortgage interest you paid in addition to your home equity loan interest. However, there’s one exception: If you tapped your equity with a cash-out refinance by borrowing more than you owed on your previous mortgage, you won’t be able to deduct the interest for the higher loan amount unless it was used for home improvements.

Mortgage points.  A mortgage point, more commonly called a “discount point,” is money paid up front in exchange for a lower rate. In most cases, you’ll deduct mortgage points over the life of the loan, but you can write them off in the year you pay them if three conditions are met:

  1. The loan is secured by your primary residence or second home
  2. The points didn’t cost more than what is typically charged in your area
  3. The points weren’t paid to replace other closing costs such as title or appraisal fees

State and local taxes. The current tax laws allow you to deduct state and local taxes of up to $10,000 for single taxpayers and married couples that file jointly. The deduction limit drops to $5,000 for married couples that file separate returns. As with point deductions, you’ll have to itemize to get a tax break with property taxes.

Capital gains on the sale of your home. Capital gains tax laws allow you to keep a portion of the profits tax free when you sell your home. Married couples can keep up to $500,000 of their sale-related gains tax free; for individual filers, the number is $250,000. As long as you lived in the home as your primary residence for two of the last five years before it was sold, you’ll be eligible for this tax benefit.

Home office deduction. If you can prove you use some of your home’s square footage for business purposes, you may be eligible for this deduction. You’ll need to prove the home address is the same as your business location. You can take the deduction based on a percentage of how much of your home is used for business, or based on a flat $5-per-square-foot rate for up to 300 square feet.

What to expect for the 2020 tax year

This is the last year you’ll be able to take the residential energy credit. You may be able to get a tax credit equal to 22% to 30% of the improvement costs toward eco-friendly improvements like installing solar panels or energy-efficient appliances. The incentive expires on Dec. 31, 2021.

Also, remember that you can’t deduct your home equity loan interest if you take the standard deductions, which are slightly higher in 2021 versus 2020. If you aren’t sure whether to itemize or take the standard deduction, contact a tax professional for guidance.

 

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