Can I Deduct HELOC Interest on Rental Property?
The deductibility of HELOC interest on a rental property depends on how the funds are used, not the loan itself. Learn the IRS rules and documentation needed.
Recent tax law changes have created uncertainty regarding the deductibility of interest from a Home Equity Line of Credit (HELOC). It is possible to deduct this interest when the funds are used for a rental property, but this eligibility is governed by a specific set of rules. The determinant is not that the loan is secured by your personal residence, but rather how you use the money you borrow. This distinction is central to understanding its treatment for tax purposes.
The Tracing Rules for Interest Deduction
The foundation for deducting interest on a loan is the IRS’s “tracing rules.” These regulations dictate that the tax treatment of interest follows the use of the loan proceeds, irrespective of the asset securing the debt. This means that even though a HELOC is secured by your primary residence, if you use the funds for your rental property business, the interest is treated as a rental property expense.
To illustrate, imagine you draw $50,000 from a HELOC secured by your main home. If you use that entire amount to purchase a new rental property or to pay for a significant renovation on an existing one, the interest that accrues on that $50,000 is considered rental mortgage interest. The use of the funds connects the interest directly to the rental activity, making it a potential business expense deduction.
Conversely, if you were to use that same $50,000 HELOC draw to pay for personal, non-deductible expenses, such as buying a boat or paying off credit card debt, the interest would not be deductible as a rental expense. The character of the expense is defined by its purpose. This principle is why record-keeping is important to prove a clear trail from the HELOC draw to the expenditure.
The Tax Cuts and Jobs Act of 2017 introduced changes that affect home equity debt, but these rules primarily impact deductions for personal use. The total amount of debt on which you can deduct interest for your primary and secondary homes is capped at $750,000 for loans taken out after December 15, 2017.
Requirements for Deducting HELOC Interest as a Rental Expense
To claim a deduction for HELOC interest, the funds must be used to buy, build, or substantially improve the rental property. The IRS defines a “substantial improvement” as an expenditure that adds to the property’s value, prolongs its useful life, or adapts it to new uses. This is different from a simple repair, which keeps the property in its current operating condition. For example, replacing an entire roof is a substantial improvement, while patching a small leak is a repair.
Building a new deck, remodeling a kitchen, or finishing a basement are examples of substantial improvements. In contrast, routine maintenance like painting, fixing broken windows, or replacing a faulty faucet are considered repairs. While the costs of repairs are immediately deductible as rental expenses, the interest on a HELOC used to pay for them is not. The borrowed funds must be for a capital improvement that is then depreciated over time.
A primary requirement is maintaining records to satisfy the IRS tracing rules. You must be able to prove how every dollar from the HELOC was spent. The best practice is to deposit the HELOC funds into a separate bank account used exclusively for the rental property project. This creates a clean financial trail to connect the loan to the expenditures.
Your documentation should include the HELOC statements showing the specific draw of funds, bank statements from the separate account, and the corresponding invoices or receipts for the rental property expenses. For a property purchase, this would be the settlement statement. For improvements, it would be detailed invoices from contractors and receipts for materials. Without this clear evidence, the IRS could disallow the deduction.
How to Report the Deduction on Your Tax Return
Once you have confirmed the deductibility of your HELOC interest, you will report the expense on Schedule E (Form 1040), Supplemental Income and Loss. The interest deduction is not taken on Schedule A, which is used for itemized personal deductions like home mortgage interest on a primary residence.
The deductible HELOC interest is reported on the “Mortgage interest” line of Schedule E. You will list the total amount of interest paid during the year that is directly attributable to the funds used for the rental property. This requires careful calculation, as the amount you can deduct may not match the total interest reported by your lender on Form 1098, Mortgage Interest Statement.
It is common for a HELOC to have a “mixed-use.” For instance, you might draw $60,000 from your HELOC, using $40,000 for a rental property kitchen remodel and $20,000 for personal debt consolidation. In this scenario, only the interest that accrues on the $40,000 portion is deductible on Schedule E. You must track the interest applicable to the rental portion separately from the personal portion.
The Form 1098 you receive from your lender will show the total mortgage interest paid on the entire HELOC balance. It is your responsibility to use your own records to determine the precise amount that qualifies as a rental expense. Your detailed records from tracing the funds are what substantiate the figure you report on Schedule E, not the total on the lender’s form.