Do I Have to Pay Taxes on a Home Equity Loan?
Understand the tax implications of home equity loans. Discover how your loan proceeds are handled and when interest expenses might be deductible.
Home equity loans allow homeowners to borrow money using their home as collateral. These financial products provide a lump sum or a line of credit based on the equity built in a property. Understanding the tax implications of a home equity loan is important, as the rules can be nuanced, particularly regarding interest deductibility. This article clarifies the tax treatment of the funds received and the interest paid on these loans.
Tax Treatment of Home Equity Loan Proceeds
The money received from a home equity loan is not considered taxable income. This is because a home equity loan represents a debt that must be repaid, rather than earned income like wages or investment gains. When you borrow funds, you are simply converting a portion of your home’s equity into cash, creating a liability that offsets the asset received.
This distinction is important, as it differentiates borrowing against your home from other financial activities that might generate taxable income. The core principle is that a loan creates an obligation to repay, which means the funds are not a net increase to your wealth in the same way income would be.
Deductibility of Home Equity Loan Interest
The deductibility of interest paid on home equity loans is a significant consideration, though the rules have changed over time. For interest to be deductible, the loan proceeds must be used to buy, build, or substantially improve the home that secures the loan, whether it’s your main home or a second home.
Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, interest on home equity loans was generally deductible regardless of how the funds were used, up to certain limits. The TCJA altered these rules, suspending the deduction for interest on home equity debt if the proceeds were not used for home acquisition or improvement. This change applies to tax years 2018 through 2025.
The total amount of mortgage debt, which includes your primary mortgage and any home equity loans, cannot exceed $750,000. For those married filing separately, this limit is $375,000. However, if the mortgage debt was incurred before December 16, 2017, higher limitations of $1 million ($500,000 for married filing separately) may apply.
Examples of qualified home improvements include adding a new room, replacing a roof, or undertaking a major kitchen or bathroom remodel. Conversely, using home equity loan funds for personal expenses such as consolidating credit card debt, paying college tuition, or financing a vacation would not qualify the interest for deduction. To claim the deduction, taxpayers must itemize deductions on Schedule A (Form 1040).
Tax Reporting for Home Equity Loans
When you pay interest on a home equity loan, your lender reports this information to you and the Internal Revenue Service (IRS). Lenders are required to send Form 1098, “Mortgage Interest Statement,” if you paid $600 or more in mortgage interest during the year. This form will show the total amount of interest you paid on your home equity loan.
As a borrower, you use the information provided on Form 1098 to determine the deductible amount of interest, if you qualify. This amount is then reported on Schedule A (Form 1040), “Itemized Deductions,” when you file your federal income tax return.
Maintaining accurate records is important when dealing with home equity loans and potential interest deductions. You should keep all receipts and invoices that document how the loan proceeds were used, especially for home improvement projects. This documentation can be helpful in substantiating your deduction claims in the event of an IRS inquiry.