A HELOC (home equity line of credit) can be a valuable tool to help pay off current debts (such as tax or credit card debt), make home improvements, or pay for emergencies
Laws regarding how a HELOC affects your taxes changed beginning in 2018 and became less straightforward
For the 2022 current tax year, interest paid on a HELOC can be deducted when used to "buy, build, or substantially improve" the home secured by the loan
For HELOCS taken out after December 2017, the interest can be deducted on a maximum of $750,000 in debt from the combined primary mortgage and HELOC
A home equity line of credit (HELOC) is a type of home loan that uses the equity in your home as collateral. HELOCs became popular in the early 2000s because the interest paid was generally tax-deductible*. However, the deductibility of HELOCs was greatly restricted starting with the 2018 tax year, making it more challenging to determine whether you can deduct the interest on the loan.
A HELOC can be a great tool if you have built up equity in your home but need cash now for projects, investments, or expenses. A HELOC can be used to make home improvements, consolidate debts, or pay off current expenses. This article explains what a HELOC is, how it works, the details of the new tax interest deduction laws, and how these new laws affect your taxes for the 2022 tax year.
What is a HELOC?
HELOC is short for home equity line of credit. A HELOC is among the ways you can use your home equity to borrow money. Home equity is the difference between what your current home value and how much you owe on your mortgage. Several financial tools are available to access cash based on the equity you have in your house. These include traditional home equity loans, cash-out refinance, and home equity lines of credit (often called HELOCs). A HELOC is seen as the most flexible option because you are able to make multiple draws of money for the amount you need. HELOCs can be approved quickly and usually have fixed interest rates (as opposed to variable interest rates), so there are no surprises.
Homeowners have traditionally used HELOCs to pay for a variety of expenses. These include home improvement projects, medical bills, credit card debt, debt consolidation, tax debt, and education. However, the latest changes in federal tax laws have substantially restricted tax deductibility of HELOC interest payments. For 2022 taxes, you can only deduct the interest if the HELOC was used to make significant home improvements.
With a traditional HELOC, you receive a line of credit based on your home equity. You can draw on the credit line for a period of time known as the draw period, during which time you will make monthly payments. After the draw period ends, you will have to repay the remaining balance on the HELOC with a variable interest rate. The Figure Home Equity Line works a bit differently: you receive the total amount of the loan at closing, and then pay back the loan on a standard amortization basis with a fixed interest rate†. However, you have the option to make some additional draws once you have repaid a portion of your principal. These additional draws will also be at a fixed interest rate, though they will be established at the time of the additional draw.
How does a HELOC affect your 2022 taxes: Current tax law
The Tax Cuts and Jobs Act of 2017 (TCJA) was passed in December 2017. It took effect for the 2018 tax year and will remain in effect through the 2025 tax year. The new law complicates the tax situation for homeowners who take out HELOCs. In general, it's now more difficult to deduct the interest on HELOCs. Some factors that affect the deductibility of interest on HELOCs are how much money you spend and what you do with the money.
While the deductibility of home-loan interest has been restricted, it's still an improvement over earlier proposed versions of the current tax law, which would have completely eliminated this deduction for all HELOCs. The IRS issued an advisory on this subject to help clear up any confusion.
According to the IRS, you can deduct the interest you pay on a home loan only if you use the funds to “buy, build or substantially improve” the property that secures the loan. Thus, the new law would allow the interest deduction for projects that improve the house itself, such as replacing the roof and remodeling a room. However, it would not permit deductions for interior decorating and new furniture. This restriction will be in effect until 2026.
Interest on a HELOC cannot be deducted for any purpose other than home improvements, even if it makes good financial sense. For example, many people use the money from a HELOC to pay off debts, such as credit card debt, or to pay their annual IRS tax bill. This is often a good decision even without any tax deduction benefits because credit cards typically have a higher interest rate than a HELOC.
Other uses for a HELOC include paying for college tuition, elder care, or medical bills. Private student loan debt can come with larger, variable interest rates, and financing elder care with a personal loan or credit card comes with the same problem. Even without the annual tax advantage, a HELOC may be the smartest way to finance such expenses.
HELOC tax deduction purchase limits
The Tax Cuts and Jobs Act of 2017 also limits the deductibility of HELOC interest based on the loan amount. For a HELOC taken out after Dec. 16, 2017, interest is fully deductible if combined primary mortgage and HELOC balances total $750,000 or less for single filers and married couples filing jointly (or $375,000 or less if married but filing separately). This is, of course, only when itemized deductions demonstrate the HELOC was used for home improvements. For loans taken out before the passage of TCJA, you can still deduct mortgage interest on loans up to $1 million. This includes first and second mortgage loans on a primary or second home.
Tax interest deduction limits on primary mortgages
The current tax plan, which applies to the 2022 tax year, also lowers the amount of a first mortgage for which you can deduct the interest. Homeowners who bought their home prior to Dec. 16, 2017, can deduct the interest they paid on up to $1M in total mortgage debt. However, this limit was reduced to $750K for the 2018 tax year, according to Financial Planner.
This limit applies to your total property debt, not just your principal residence. Assume, for example, that you owe $500K on your primary residence and $500K on a vacation home. Single filers or married couples filing jointly would get to deduct only the interest paid on $750K in mortgage debt; none of the interest you paid on the other $250K would be deductible. However, two single people could buy a house for $1.5M and each of them could deduct the interest on $750K in mortgage debt. These limits won't apply to the majority of homeowners, since Zillow reports that the median price of a home in the U.S. in 2018 was $207K -- well under the $750K threshold.
Can you use a HELOC to pay off tax debt?
While the Tax Cuts and Jobs Act of 2017 does limit the circumstances under which you can deduct the interest paid on a HELOC, it does not restrict how you can use it. If you have a large tax bill for the 2022 fiscal year (that is, taxes due in 2023) that you are not able to pay, a HELOC might be a good option for you. Interest rates are fixed and are usually lower than variable-rate personal loans or IRS payment plans often used to pay a tax debt.
The deductibility of interest has historically been one of the biggest advantages of a HELOC over other types of loans. As of 2018, homeowners who had planned to use a HELOC for something other than home improvements may still be the best all-around option due to payment flexibility and lower, fixed interest rates.
*You should consult a tax advisor regarding the deductibility of interest and charges to your Figure Home Equity Line.† The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw.