Homeowners frequently use their home equity to consolidate debt, finance home improvements, pay for college tuition, or even to take vacations. One of the biggest reasons in favor of doing so is the expected tax deductibility of the second lien's mortgage interest. In these instances, you are always instructed to "consult your tax professional" before committing to an offer. If you have ever actually done this, you're in the minority. The deductibility of mortgage interest -- especially home equity interest -- can be a complex problem that should be addressed when you're considering a home equity loan, so you probably ought to. Why is it so complicated?
Home Equity Interest Must Be Right On Schedule (A)
This is the first hurdle. According to the Tax Policy Center, only 35% of taxpayers itemize their deductions. For the other 65%, the deductibility of mortgage interest isn't relevant. If you have a high standard deduction (e.g., you're the head of the household), a low to moderate income, or a smaller mortgage, government data suggests that you are less likely to deduct your interest than a high-income individual with a million-dollar home loan.
If you do itemize your deductions, your mortgage interest goes on a Schedule A. Keep in mind that if you didn't itemize before taking out a home equity loan, the extra interest payments might make itemizing your deductions pay off. Running the numbers through a tax software program, or (here it comes!) consulting that tax advisor could tell you if deductibility is a benefit that you can take advantage of. If not, a home equity loan might still make sense, but deducting the interest is not a consideration.
There Are Limits for a Home Equity Deduction
The amount you can deduct in home equity loan interest may be limited -- the IRS only allows you to deduct the interest on a home equity loan up to a loan amount of $100,000. The $100,000 limit applies to all home equity mortgages, whether it's a single loan against your primary residence, or several loans against your primary or secondary homes. Only residential rental properties are not subject to this limitation. There can be exceptions to the $100,000 rule, such as the creation of a home office.
Mortgages that Exceed Your Home's Value Are Not Deductible
For deductability, the loan must be secured by your home. This does not mean that if your home's value drops to less than your mortgage balance(s) your interest won't be deductible. It means that if you were somehow able to get a second mortgage that pushed your total mortgage liability to more than the value of the home (e.g., the 125% LTV mortgages sold in the past), the interest on amounts exceeding the fair market value of your property would not be deductible, even if your home equity debt was less than $100,000. For example, say you have a house worth $100,000 and a $75,000 first mortgage against it. If you were somehow able to get a $50,000 home equity loan, the total loan balance secured by the property would be $125,000. Only the interest on the first $100,000 is deductible. The interest on the excess $25,000 is not.
Home Office Headache
In addition, using part of your home as a rental or home office skews this calculation. The percentage of your home's value attributable to other use comes out, but interest may be deductible as investment interest. In that case, you really have to check with a tax pro.
The Exception to the Rules
If you take out a home equity loan or line of credit for home improvement, take the above information and toss it in the trash. Loans taken to improve your property are considered the same as loans taken to buy it -- it's all considered "acquisition debt," and as long as your total mortgage debt doesn't exceed $1,000,000 ($500,000 if married and filing separately), you should get to deduct your mortgage interest.
Now you can probably see why mortgage lenders just ask you to "consult your tax professional."
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.