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What are the tax benefits of a Home Equity Line of Credit?
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What are the tax benefits of a Home Equity Line of Credit?

Understanding tax benefits of a home equity line of credit

Depending on how you use the funds, interest payments from a home equity loan or home equity line of credit might be tax deductible when filing your annual taxes. When it comes to financing a large purchase or trying to pay off debt, home equity loans and lines of credit can be a great option. They provide access to capital when you need it and are backed by the security of your own home.

The tax implications of a home equity loan or line of credit can be confusing. People usually turn to these solutions when they need cash and have equity in their homes, but the rules related to whether the interest payments on these loans are tax-deductible have changed significantly recently. Interest on HELOCs (Home Equity Lines of Credit) and home equity loans is tax deductible when used for certain types of home improvements on the property for which you received the loan or line of credit.

If home improvements are part of your plan this year, you may be surprised to hear that you can still deduct interest on home equity loans and lines of credit. Although tax laws have changed in recent years, home equity debt still has tax benefits that can effectively reduce the cost of home improvement projects.

Before 2018, deducting interest paid on home equity loans was relatively straightforward. But the 2017 Tax Cuts and Jobs Act (TCJA) changed things. Now, you can deduct interest costs on home equity debt only when you use the funds to buy, build, or make substantial home improvements.

When it comes to making sure that any interest paid is eligible for a deduction, there are a few key things to keep in mind. To qualify, the funds must be used on the property from which the loan or line of credit was taken out; if this isn't adhered to then the interest will not be deductible. Additionally, borrowers can only deduct interest on up to $750,000 of residential debt—including mortgages, home equity loans and HELOCs—but older mortgages may still be eligible under the previous $1 million limit (or $500,000 for married taxpayers filing a separate return). It's important to factor these limits into any decisions about taking out a HELOC or other form of home equity product as this will ensure savings in terms of taxes in the long run.

New rules for home equity tax deductions under TCJA

Rules on how to deduct interest payments on home equity (such as traditional loans and home equity lines of credit) changed in 2017 with the passing of the Tax Cuts and Jobs Act. Home equity debt is allowed to be tax deductible if the funds are used for certain home improvements. This applies to loans existing before the new tax law as well as those taken out afterwards. To satisfy the rules, a married taxpayer filing separately must take out a loan of at least $375,000; all other individuals much have new loans of up to $750,000. Furthermore, the homeowner must use the funds on property where they have the home equity and they must use the money to "buy, build or substantially improve" said property. Interest on mortgages from before the 2017 TOCJ Act passed retains a legacy limit to tax deductions on up to $1 million in mortgage debt. 

In addition to these rules and limits, it is important to remember that this maximum limit on deductions applies to all residential debt taken together. Homeowners should carefully assess their needs and circumstances before establishing any sort of loan agreement with regard to improving their home. By adhering closely to these regulations, homeowners may utilize this tax benefit in a manner that maximizes the advantage in paying for renovations.

How to claim deductions on home equity loan or HELOC interest

The home equity loan interest deduction allows homeowners to deduct the interest paid on loans taken out against their home's value. This can result in sizable savings and is a great way to offset the cost of renovations and home improvements. It's important to keep a few things in mind when claiming home equity debt interest deductions on your taxes.

First, the funds must be used for expenses directly related to renovations or other improvements made on the primary residence that backs the loan—claiming the deduction for debt consolidation, personal expenses, or even improvements on another property is not allowed.

It is crucial to keep proper records of these expenses in order to document their purpose for qualification and eligibility for tax deductions. This means keeping copies of all receipts and bank statements to show exactly how the money was used in case of an IRS audit. By keeping proper records of all expenditures with these funds, you ensure your ability to take advantage of this significant tax break. The deduction is available to taxpayers who itemize using the Schedule A income tax form. For itemizing to make sense, you typically need deductible expenses sufficient to exceed the standard deduction. For 2019, the standard deduction is $24,400 for married filing jointly, $12,200 for individuals, and $18,350 for heads of household. Deductible expenses might include mortgage interest, charitable contributions, and other items.

If you are claiming tax deductions on one or more mortgage, home equity loan, or home equity line of credit from before the 2017 TOCJ Act passed, it is important to talk to an accountant to see how to itemize your deductions, since the cap limit reduced from $1 million to $750,000.

Benefits of home improvement

Home improvement projects, which often qualify as substantial improvements, can potentially help you reduce your taxable income. But you get more than tax benefits, including:

Increased value Renovations typically add to your home's value. A smart way to borrow against home equity is to reinvest in your home. Doing so allows you to potentially sell your house at a higher price, providing funds to pay off debts or put toward your next property.

Better quality of life You can also make your home more comfortable to live in, more efficient, and more useful for your needs. Financial benefits are always nice, but spending time in a home you enjoy is also a worthy goal.

Substantial improvements You must use the proceeds of a home equity loan to buy, build, or substantially improve your home. Since you already own a home, you would presumably use funds to renovate your property.

Secured loan To deduct interest, the loan should be secured by the same property that you are buying, building, or improving. As a result, using equity from your primary residence to buy a second home might not qualify for the deduction.

Examples of home equity line of credit tax deductions:

Here are some basic examples to illustrate how to benefit.

Example 1:
Your current mortgage loan balance is $250,000, and you have enough equity to borrow more for substantial improvements. You borrow an additional $200,000 against your home and use the proceeds for home improvements. Because your total home equity debt is less than $750,000 and both loans are secured by the same home you're improving, the interest could potentially be deductible.

Example 2:
You have significant equity in your home, and you want to consolidate high-interest-rate credit card debts, as well as pay tuition costs for your child. You borrow $100,000 against your home to do so. However, because the loan proceeds did not go toward substantial improvements to your home, you most likely cannot deduct the interest on the loan.

Example 3:
You own your primary residence free and clear. You want to buy an investment property, improve it, and rent it out. You borrow $300,000 for a down payment and operating expenses. However, because the investment property loan is secured by your primary residence (a different property), you most likely cannot deduct the interest on the loan. If the $300,000 loan was secured by the investment property (the same one you're buying, building, or improving), the interest could potentially be deductible.

Evaluate the pros and cons

Paying for home improvements with a home equity loan may be a wise strategy, and tax laws still allow you to deduct interest expenses in some cases. Evaluate the pros and cons of different funding sources, and speak with a tax professional to verify how the strategy might work in your situationDisclaimer1.

Itemizing for your loan's interest may provide additional opportunities for you to save on taxes. For example, if you make charitable contributions, those contributions may become tax deductible when you itemize, making it affordable to give more than you were previously planning to give.

Should I still get a HELOC or home equity loan if the interest isn't deductible?

Taking out a home equity line of credit (HELOC) may be worth it even if the interest isn't deductible, depending on how you need the money. For example, if you're looking to consolidate existing debt like credit cards, then a HELOC might offer much lower interest that you could use to save money in the long run. This is only true if you plan to pay off your HELOC as quickly as possible and don't add new debt with your already-paid credit cards. You can also use a HELOC for remodeling projects or other large investments that will end up increasing the value of your house over time. Consider costs, fees associated, and potential risks with opening a home equity line of credit or home equity loan to determine if the benefit will outweigh the costs.

  1. Disclaimer 1You should consult a tax advisor regarding the deductibility of interest and charges to your Figure Home Equity Line.

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