When you take out a personal loan or borrow from a credit card, for example, you pay a higher interest rate and cannot claim a deduction on your taxes.
On the other hand, you might be able to deduct the interest you pay on your home equity loan from your federal taxes.
How Tax Plan Changes Affected Home Equity Loans and HELOCs for 2018 and Beyond
Prior to 2018, there were no qualifications on the tax deductibility of interest paid on a home equity loan or HELOC. Borrowers could take out a home equity loan or HELOC for any purpose and still deduct the interest on their taxes.
Congress passed a new law in December 2017, however, that changed the way the IRS considers home equity loans and HELOCs. So if you take out a home equity loan or HELOC to consolidate debt, pay off credit card debt, buy a car, pay for medical expenses, go on vacation, or pay for college, the interest is no longer tax deductible. You can still use the loan proceeds in any way you want, but you will only be able to claim the interest deduction on your federal taxes under a few specific conditions.
From 2018 until 2026, interest on home equity loans and HELOCs is only tax deductible if the borrower uses the proceeds to buy, build, or substantially improve the home that secures the loan. For example, you can deduct the interest if you use the proceeds to build an addition onto your home, renovate your kitchen, or replace your roof.
There are also new limits to the amount of interest that a borrower is allowed to claim. Prior to 2018, borrowers could deduct the interest on up to $1 million of loans on a qualified residence.
In 2018, Congress lowered the limit to interest on $750,000 in loans for a qualified residence and $375,000 for married taxpayers filing separate returns. A qualified residence is your main residence in which you reside for most of the year.
In addition to their main residence, taxpayers can claim mortgage tax benefits on one additional second residence as long as they do not earn rental income from the second home.
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How Deducting Home Equity Loan Interest from Taxes Works Now
The following example illustrates how the tax deduction on home equity loan interest or HELOC interest can aid borrowers:
First, consider a situation where your household has taxable income of $100,000 per year. You want to borrow money to cover the cost of a master bath renovation. Instead of taking out a home equity loan, you put the money on your credit card and pay 25 percent interest annually. You have a 30 percent marginal tax rate and do not get to deduct the interest on your credit card from your taxes. Your after-tax income is $70,000.
Taxable Income x Tax Rate = Tax Due
$100,000 x 0.30 = $30,000
Now consider an alternative situation in which you take out a home equity loan at a rate of 5 percent and get to deduct the interest paid on the loan from your taxable income. If you borrow $20,000, you’ll pay approximately $1,000 in interest over the year ($20,000 x 0.05 = $1,000). This reduces your taxable income to $99,000. Your after-tax income is $69,300 for a $700 annual tax savings.
Taxable Income x Tax Rate = Tax Due
$99,000 x .30 = $29,700
On the surface, the tax savings might not seem significant. You must consider, however, that the savings get bigger as the loan amount, loan interest rate, or marginal tax rate increase. In addition, the effective cost of borrowing with a secured home equity loan is much lower than the cost of borrowing with credit cards and personal loans.
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