See what's happening with home values in more than 400 metropolitan areas with HSH's Home Value Tracker, just updated though the second quarter of 2022.

See what's happening with home values in more than 400 metropolitan areas with HSH's Home Value Tracker, just updated though the second quarter of 2022.

Home Equity Loans and the IRS: Things You Need to Know

HSH Editors Image

Homeowners frequently use their home equity to consolidate debt, finance home improvements, pay for college tuition, or even to take vacations. Aside from offering a low cost way to borrow and lengthy repayment terms, one of the biggest reasons in favor of doing used to be the expected tax deductibility of the second lien's mortgage interest.

A lot of that changed with the Tax Cuts and Jobs Act of 2017.

To start with, whether or not you will be itemizing deductions on your tax returns at all will depend on a number of factors. The new standard (non-itemizing) deduction for a married couple filing jointly was $25,100 for tax year 2021, and that's a high hurdle for many homeowners to get over to make it worth the time and effort to itemize their deductions, including mortgage interest.

Even if you subtract the maximum amount of state and local taxes (SALT) that can be deducted means you'll need more than $15,000 in mortgage interest (and other deductions) to even reach that threshold. That's a fairly large expenditure hole to fill. By way of example, a 4% 30-year fixed rate mortgage of $400,000 produces $15,872 in interest in its first year; loan amounts less than this or loans with an interest rate below 4% don't even reach this high. Also, if it has a fixed interest rate, the amount of interest you pay on your mortgage declines each year, so even if you make it in the early years of your loan you may not reach this level as time progresses.

The other significant change from the 2017 TCJA: Where interest on home equity debt up to $100,000 used for any purpose could formerly be counted toward your mortgage interest deduction. that's no longer the case. Now, only interest incurred on equity draws used to "buy, build or substantially improve" a primary residence or second home qualifies as deductible mortgage interest.

In addition, the TCJA also imposed new total loan limits on mortgage interest deductibility. Formerly, interest on mortgages of up to $1,000,000 qualified for deduction for married couples, but this was reduced to $750,000 starting with the 2017 tax year..However, if your existing first mortgage was made before December 16, 2017, the old higher limits still apply. This change complicates accounting and can add confusion when it comes to figuring out your mortgage interest deduction.

With this as a backdrop, no wonder the standard advice before making use of your home equity has always been "consult your tax professional". Of course, if you have ever actually done this or plan to do so, you're likely in the minority. The deductibility of your mortgage interest (or not) is something that should be considered before you take out a home equity loan, and you probably should do some research into your situation beforehand to understand how it may work for you.

Home Equity Interest and Schedule (A)

According to the Tax Policy Center, only about 13% of taxpayers itemized their deductions in 2018. For the other 87% who use the standard deduction, the deductibility of mortgage interest isn't relevant. For borrowers with a higher standard deduction (e.g., filing as head of the household), those with 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. In addition, many homeowners refinanced in recent years at record-low rates, and may no longer be paying enough mortgage interest to qualify to itemize even if they have a considerable amount of other deductions to include.

If you will itemize your tax deductions, your mortgage interest goes on Schedule A. Keep in mind that if you didn't itemize before taking out a home equity loan or line of credit, the extra interest payments might make itemizing your deductions pay off. Running the numbers through a tax software program or talking to a tax advisor could tell you if mortgage interest deductibility applies in your situation. If not, borrowing using your home equity might still make sense, but deducting the interest won't be a consideration.

If you do use a home equity loan or line to "buy, build or substantially improve" a primary or secondary residence, the onus is on you to keep solid records of what you bought with your home equity proceeds. In the event of a future audit, you'll need receipts to prove that your equity-based spending met the criteria for deductibility.

Limits on Deducting Home Equity Interest

Figuring out how much interest on home equity debt was deductible used to be pretty straightforward, since it was up to $100,000 for any purpose. Now, you may be subject to the $1,000,000 maximum ($500,000 filing single) or $750,000 / $375,000 limits on mortgage debt depending on when you bought your home -- and your total mortgage debt subject to deductibility can't exceed the limit in place from that time.

The IRS has a page explaining how these mortgage interest caps work.

One such example says "In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible."

In the same way, a homeowner who bought a $1,000,000 back before December 2017 home with a $900,000 mortgage might have seen its value rise to $1.3 million. He or she now has borrowable equity and a lender may allow them to pull out as much as $140,000 -- but only $100,000 of it would qualify for deductibility, since the other $40,000 -- even if used to buy, build or substantially improve the home -- is excess of the million-dollar cap.

Mortgages that Exceed Your Home's Value Are Not Deductible

For deductibility, 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 total mortgage debt remained under the maximum cap. 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. Since it's secured debt, the interest on the first $100,000 of the loans is deductible, while interest on the excess $25,000 is not.

If you plan on taking out a home equity loan or line of credit and expect to use the proceeds for anything other than "buying, building or substantially improving" a primary or secondary residence, you won't be able to deduct the interest you paid. However, that's not really all that much of a drawback; interest deduction or not, using your home equity can offer fairly easy access to funds at interest rates that can be lower than other forms of borrowing.

Gina Pogol originally authored this article; it was revised and updated by Keith Gumbinger.

Add to Homescreen?
Install this web app on your phone :tap and then Add to homescreen