Taxes and Home Equity Loans

A home equity loan can be an excellent way to access the funds needed for home improvements, debt consolidation, or other significant expenses. But before you take out a home equity loan, it’s essential to understand how taxes come into play. After all, taxes are a big part of how a home equity loan works.

In this guide, we’ll discuss the ins and outs of taxes associated with home equity loans, including interest deductibility and any potential tax implications. First, let’s take a look at how a home equity loan works.

How Does a Home Equity Loan Work?

A home equity loan is a type of loan that allows homeowners to borrow money against the equity they’ve built up in their property. Equity is the difference between the current market value of the home and the outstanding mortgage balance. Home equity loans are often called “second mortgages” because they are secured by the borrower’s home, just like a primary mortgage. Homeowners can typically borrow up to 80-90% of their home’s equity, depending on credit score and loan-to-value ratio (LTV).

Now that we better understand how home equity loans work let’s delve into the tax implications.

Interest Deductibility

One of the key benefits of home equity loans is the potential tax deductibility of the interest paid on loan. According to the Internal Revenue Service (IRS), the interest paid on home equity loans is generally deductible if the loan proceeds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan.” This means that if you use the home equity loan for home improvements or renovations, you may be able to deduct the interest you pay on your taxes.

However, there are some important limitations and restrictions to keep in mind:

Loan amount: The IRS limits the total home equity debt that can be considered for interest deductibility. As of 2021, the limit is $750,000 for married couples filing jointly and $375,000 for single filers or married couples filing separately. This limit applies to the combined total of your primary mortgage and home equity loan.

Home improvements: To qualify for interest deductibility, the funds from the home equity loan must be used for substantial home improvements or renovations. Using the loan proceeds for personal expenses, debt consolidation, or other non-qualifying purposes will not allow you to deduct the interest paid.

Itemized deductions: To claim the interest deduction on a home equity loan, you must itemize your deductions on your tax return. This means you’ll need to weigh the potential tax benefits against the standard deduction, which may be more advantageous depending on your financial situation.

Potential Tax Implications

While home equity loans can offer tax advantages, there are also potential tax implications to be aware of:

Capital gains tax: When you eventually sell your home, the proceeds from the sale may be subject to capital gains tax. If the home equity loan were used for qualifying home improvements, the cost basis of your home (the original purchase price plus improvements) would increase, potentially reducing your capital gains tax liability. However, suppose the loan proceeds were used for non-qualifying purposes. In that case, your cost basis will remain the same, possibly leading to a higher tax liability upon the sale of your home.

Foreclosure and tax implications: Since a home equity loan is secured by your property, defaulting on the loan can lead to foreclosure. Sometimes, the forgiven debt from a foreclosure can be considered taxable income, resulting in additional tax liability.

Conclusion

Taxes and home equity loans are closely intertwined, and homeowners must understand the potential tax benefits and implications before taking out a home equity loan.

Using loan proceeds for qualifying home improvements, you may be able to take advantage of the interest deductibility, providing potential tax savings. However, consider the limitations and restrictions surrounding interest deductions and the potential tax implications, such as capital gains tax and foreclosure-related tax liabilities.

As always, consult with a tax professional or financial advisor to assess your situation and determine the best action when considering a home equity loan. By being well-informed about taxes and home equity loans, you can make more educated financial decisions and potentially maximize your tax savings.