Is Home Equity Loan Interest Tax Deductible?

So it’s tax season, and you’re wondering whether or not you can deduct the interest accrued from your home equity loan. The short answer is — it depends. Your ability to deduct the interest hinges on what you used the funds from the loan for.

Home equity loans are quite common, and the frequency they are being taken out depends on a variety of factors, from financial need to fluctuating market trends. Here, you will learn everything you need to know about home equity loans, how people use them, and how you can deduct the loan interest come tax time.

What Is a Home Equity Loan?

A home equity loan, commonly referred to as a “second mortgage,” allows a homeowner to borrow against their home by leveraging its equity. “Equity” is the difference between what you currently owe on the balance of your home and how much your home is worth on the market.

If you were to list your home for sale after paying off its balance, equity is what you would receive after a successful closing. So, if your home is worth $400,000 according to the market, but you owe $300,000, you would receive $100,000 in equity when the sale is complete (assuming the property is sold at market value).

A home equity loan is paid to you as one lump sum that you are required to repay on a monthly basis. The payments are usually fixed, so there shouldn’t be any surprises.

Why Take Out a Second Mortgage?

There are several reasons why someone might take out a second mortgage, the most common being home improvement. People want to reinvest back into their homes, especially when the market is up and property values are on the rise.

Other reasons someone might take out a second mortgage include:

Financial need. Sometimes homeowners take out a home equity loan to dig themselves out of debt (like student loans or credit card debt). This is usually a last resort after all other resources have been exhausted; it’s not something done on a whim.
Investment opportunity. When the market is doing well, borrowers will often jump at the chance to invest their money and watch it grow.
Retirement fund. Occasionally, homeowners will use the funds from their second mortgage towards retirement, but this is much less common than other reasons.
Miscellaneous or leisure. Sometimes, people take out second mortgages for personal, private reasons. Ultimately, homeowners can do what they wish to with the funds, and there doesn’t have to be any particular reasoning for taking them out.

The majority of homeowners are taking out second mortgages on their homes to better their properties and increase their value. This will prove to be quite beneficial when tax season comes around.

How Long Do You Have To Pay It Back?

You’ll make fixed monthly payments (with interest) throughout the duration of your home equity loan. This is no different from your initial mortgage agreement.

You can take up to 30 years to pay it back if you need to. However, most people select a loan term of anywhere from five to 20 years. The higher your mortgage interest rate, the quicker you’ll want to get that balance paid down.

If you don’t pay your home equity loan back like you agreed to, the lender has the right to send your home into foreclosure to attempt to get that money back. They can also cut off your access to any remaining equity; you cannot use it in the meantime.

Your second mortgage has just as much of an impact on your homeownership status as your initial one. You risk losing your home by defaulting on the second mortgage, even if you remain in good standing on your first mortgage and have never missed (or been late with) any payments.

What If You Want To Sell?

Are you thinking about selling your home? You can still put it on the market even if you’ve taken out a home equity loan.

Outstanding debts don’t hinder your ability to sell your property, but they do lessen what you’ll receive in the sale. At closing, any outstanding balance on the property will be taken from the final sale amount and paid out to the creditors.

What About Taxes?

Is home equity loan interest tax deductible? Only if you used the funds from that loan amount to make a qualified home significantly better than it was previously. A qualified home, according to the IRS, is your primary residence. So if you have a second home that you rent out, it wouldn’t qualify.

If you’re going to deduct anything on your tax forms, the property needs to be a qualifying residence in line with standards from the Internal Revenue Service.

Here are some instances where you could be eligible for a tax break:

You make substantial improvements. If you use the loan funds to redo your entire living room and office, you will likely qualify.
You increase your equity. Let’s say you didn’t put down the full 20 percent when you purchased your property. You could take out a second mortgage and use the funds to cover the remainder of the 20 percent down payment. This would be able to be deducted.
You build something. If you were to add another wing to your property or build an entertainment center or guest house in your backyard, you could deduct these renovations on your tax forms.

If you use the loan proceeds from a second mortgage on other personal expenses that have nothing to do with your residence, you won’t be able to claim those expenses as a deduction.

How To Claim Your Tax Deduction

In order to claim a deduction on your taxes, taxpayers will need to follow a few steps. If you have a tax professional who helps you with your taxes, you might want to do this alongside them to ensure you get it right and don’t have to appeal.

When claiming your home equity loan interest, make sure to:

1. Pull Previous Mortgage Statements

First, locate your mortgage statements from the previous year. You will receive these from your lender each year, and any interest paid needs to be reported to the IRS. If your interest payments add up to be less than $600, it’s possible you won’t even receive any communications from your lender regarding the matter.

2. Create a List of Itemized Deductions

Figure out the total amount of your itemized deductions. Unfortunately, you can’t deduct the interest from your home equity loan unless you itemize them. Commonly itemized line items include personal property taxes and charitable donations.

The more itemized items you have, the better chance you have of successfully claiming the interest of your second mortgage on your taxes. You cannot claim the interest while taking the standard deduction with current tax laws.

3. Review Your Mortgage Points

Did you use points at closing? Mortgage points are a type of discount that buyers can opt into when closing on their homes to get a better interest rate.

If you paid a little extra prior to closing on your home to lower your overall interest, you might be able to deduct this. These points are considered interest that was simply paid in advance.

4. Compare Deductions

Make sure your itemized deductions total more than the standard one. Let’s say you’re single. The standard deduction for the 2022 tax year was $12,950. If you can get your itemized deductions above that figure, you can claim the interest from your home equity loan on your taxes. You just can’t claim both the standard and home equity deductions.

Claiming your home equity loan interest could prove to be a bit difficult, particularly for married taxpayers. This is because married couples filing jointly have standard deductions that are much higher than the average single filers.

If you’re married and want to claim the interest from your home loan on your taxes, you could file separately from your spouse. However, this comes with its own set of risks.

Private Lenders and Possibilities

We are a private lending company based in South Florida that is taking the extensive waiting out of real estate transactions. We have spent decades building our skills and expertise to what they are now, and we have been happily assisting clients with their mortgages since 2017.

At Vaster, we create solutions that allow our clients to close faster and with confidence. We offer private loans for real estate investors, and we have established an extensive lender network to now offer conventional loans for home buyers as well.

Did you know that refinancing your home with us can allow you to access your equity without the monthly payment that comes with a home equity loan? We’d be happy to walk you through this process and answer any questions you might have.

Sources:

How Are People Spending Their Home-Equity Loans? | The New York Times

2021 and 2022 Tax Brackets and Other Tax Changes | Investopedia

Something Has to Give in the Housing Market. Or Does It? | The New York Times

Are Home Equity Loans Tax-Deductible? | NerdWallet