Understanding Home Equity Loan Tax Deductions

There are substantial benefits to taking home equity loan tax deductions. To make sure you get those most of those financial goodies, it is important to understand which deductions are available to you.

The Purpose of a Home Equity Loan

A home equity loan is a second mortgage that uses the borrower's equity in the home as collateral. These loans have been very popular because the acquired money can be used for anything the borrower wants. While some homeowners use home equity loans specifically to make improvements to their homes, many others use them to pay for things like business investments, debt consolidation, college tuition, or even large one-time expenses like weddings.

The Tax Benefits

The reason these loan have been so fashionable in the past is that they typically offer lower interest rates than unsecured debt and at least some, if not all of the equity loan interest is tax deductible. So, for example, you consolidate your car loans into a home equity loan. Your new interest rate could be 2 percent or 3 percent lower and you would save money again on your returns when April 15 rolls around.

How To Deduct Home Equity Loan Interest

The amount of home equity loan interest that is tax deductible depends on several factors.   How you spent the money is the first determining factor. If the funds were used for home improvement or to purchase a second home, then the IRS considers it to be part of your "home acquisition debt" and all of the mortgage interest you pay will be tax deductible, as long as the loan does not exceed $1 million. Home improvements as approved by the IRS on its website include any improvement that "adds to the value of your home, prolongs your home's useful life, or adapts your home to new uses." This would include permanent things like adding on rooms or putting a pool in the backyard, but not projects like landscaping or buying new furniture for the den.

If you used the second mortgage money for business investment purposes, you may also be able to deduct all of the loan interest as well. If your home equity loan funds were used for anything else, however, then some restrictions apply.

Limitations

Tax law stipulates that you can deduct all interest on a loan up to $100,000 ($50,000 if married and filing separately.) But if you take out a second mortgage that increases your total home loan debt to more than the value of your house, you will only be able to deduct a portion of the interest. In this case you can deduct only the interest that is paid on the difference between your home's current value and the amount you owe on your first mortgage. (Basically, this rule is in place to make sure the government is not encouraging people to make overly risky loans against their homes.)

For example, say you own a home that is now worth $200,000 and you still owe $175,000 on your first mortgage. In the past lending companies have offered borrowers home equity loans of up to 125 percent of the fair market value (FMV) of the property minus the amount of the first mortgage. So in this example you could take out a second loan for $75,000 [(125 percent x $200,000) - $175,000.] However, you can only deduct interest on the amount of true equity you have in the house, or the market value minus the  amount of your first mortgage. In this case, that would $25,000. So even though you took out a $75,000 second mortgage, you would only be eligible to deduct the interest paid on the first $25,000 of that equity loan.

A Word of Caution

Once you take out a home equity loan that exceeds the current value of your property, the tax benefits become smaller and the risk of losing your house becomes greater.  And while consolidating your debts into a lower interest rate loan can save you money over sky-high credit card rates, your home equity loan is tied to your house. If any financial tragedy should happen suddenly, you might be unable to make the payments on your equity loan and your home could be repossessed. A good rule of thumb is to only pull money out of your equity if you use it to increase the value of your home (home improvements) or increase your earning potential(business investments or your own school tuition).

Home equity loan tax deductions can certainly make these second mortgages much more appealing than other types of unsecured loans. And as long as you take out an equity loan with a sound understanding of the available tax benefits as well as the risks and limitations, those deductions can really pay off.