Learning the tax laws associated with taking out a home equity loan or home equity line of credit is an important step in deciding on the type of loan you need. Yet many people often skip or don’t even consider this procedure, and they often end up paying taxes on their loans when they shouldn’t.
Perhaps the most important move is to itemize your home equity loan or home equity line of credit interest. Experts say that fewer than 35 percent of tax filers bother to itemize their loan interest and those that do are usually have a much higher income than those who can most benefit from the deduction.
For those who do itemize their deductions, remember to place the mortgage interest on Schedule A of the tax form. You may wish to calculate the possible deductions with a tax software program like Quicken or TurboTax, or consult with a tax professional to determine if deducting your home equity loan or home equity line of credit interest is to your advantage.
Once you determine if deducting the interest on your home equity loan or home equity line of credit is to your advantage, you should next determine the amount of interest the IRS allows you to deduct. The IRS permits you to deduct interest up to $100,000 and applies to all forms of home equity loans and all home equity loans you have at the time. The IRS makes exceptions to the $100,000 limit in the case of loans related to a business, such as installing a home office or if you rent out part of your property (which can be deducted as investment interest).
Next, to be able to deduct the interest of the loan, the loan must be secured by your house. If you obtain a home equity loan or home equity line of credit that boosts the total amount of your mortgage liability above the value of your house, any interest that exceeds the market value of your house is not deductible. This is true even if the equity debt of your home is less than $100,000.
If you take out a home equity loan or home equity line of credit with the goal of home improvements, this is considered an acquisition debt and is deductible as mortgage interest (if the total mortgage debt does not exceed $100,000 or $50,000 if you are married but filing a tax return separately). An acquisition debt can also be a second mortgage taken out to buy a home. Also, if you perform a “rate and term” refinance (aimed at changing the interest rate and terms of the loan) but do not take out any additional money, this can also qualify as acquisition debt.
With a home equity loan or home equity line of credit, you are not allowed to deduct interest points (a percentage of the total loan amount) in the same year that you pay them, but you must amortize, or schedule payments, over the span of the loan. For instance, if you close your home equity loan or home equity line of credit and pay a point of $5,000, you are not allowed to deduct $5,000 in that particular tax year. You are only allowed to deduct a percentage of the $5,000 each year that you have the loan. If you refinance your loan, however, you are allowed to deduct the remaining balance of the point for that tax year.
Finally, if you received your home equity loan or home equity line of credit prior to October 13, 1987, it is considered a grandfathered loan and all interested paid on a grandfathered loan in any year is completely tax deductible. There are special exemptions and conditions beyond that point but many of the rules and conditions are not applicable to most homeowners.
As stated before, it’s probably a good decision to consult a tax professional on tax issues pertaining to home equity loans and home equity line of credit. The Taxpayer Advocate Service is a not-for-profit independent group that operates within the IRS and assists taxpayers who need help with tax issues. TAS is a free service extended to taxpayers who have not been able to resolve tax issues through normal IRS channels.
Also, you can get free help with your tax return from the Volunteer Income Tax Assistance program (VITA), a program that assists low-income tax payers and offers free e-filing of your return and can inform you of all possible deductions.
