Do You Have to Pay Taxes on a HELOC?

A Home Equity Line of Credit (HELOC) offers homeowners a flexible way to access the equity built in their property. It functions as a revolving line of credit, similar to a credit card, where funds can be drawn as needed up to a certain limit and repaid over time. The home itself serves as collateral for the loan, making it a secured debt instrument. Understanding the tax implications of a HELOC is important for homeowners considering this financing option. This article explores various tax considerations related to HELOCs, from the taxability of the funds received to the deductibility of interest paid and other potential tax events.

Are HELOC Funds Taxable Income

Money received from a HELOC is not considered taxable income. This is because HELOC funds represent borrowed money, which comes with an obligation for repayment. Unlike wages or investment gains, loan proceeds are not earnings or revenue.

The principal amount you draw from a HELOC is a liability that must be paid back to the lender. When you receive these funds, they do not increase your net worth or income for tax purposes. The IRS does not tax the receipt of loan principal itself.

Deducting HELOC Interest

Interest paid on a HELOC can be tax deductible under specific circumstances. Limitations apply to this deduction.

HELOC interest is only deductible if the borrowed funds are used to “buy, build, or substantially improve” the home that secures the loan. This means the interest is deductible if the HELOC is used for renovations or additions that enhance the value of your main home or second home. For example, using HELOC funds for a kitchen remodel or building an extension would qualify. Conversely, using the funds for personal expenses like debt consolidation, college tuition, or a vacation would not make the interest deductible.

A “substantially improved” home refers to an upgrade that adds to the home’s value, prolongs its useful life, or adapts it to new uses. This includes major projects like adding a room, finishing a basement, or installing a new roof or HVAC system. Routine maintenance or minor repairs, such as repainting a room or fixing a leaky faucet, do not qualify as substantial improvements for this deduction unless they are part of a larger qualifying renovation project.

The deductibility of HELOC interest is also subject to debt limits. The combined total of acquisition indebtedness (debt used to acquire or improve a home) and any HELOC funds used for home improvement cannot exceed $750,000. For married individuals filing separately, this limit is $375,000. This cap includes the original mortgage used to purchase the home and any subsequent qualified HELOCs.

To claim the HELOC interest deduction, taxpayers must itemize their deductions on Schedule A (Form 1040) of their federal income tax return. If your total itemized deductions, including HELOC interest, are less than the standard deduction for your filing status, it may not be beneficial to itemize.

Other Tax Considerations with a HELOC

Beyond the initial receipt of funds and interest deductibility, other tax implications can arise with a HELOC. One such consideration involves the cancellation of debt (COD) income. If a portion of your HELOC debt is forgiven or canceled by the lender, that amount can be considered taxable income. This can occur in situations like a foreclosure, short sale, or a debt settlement where the lender agrees to accept less than the full amount owed.

When a lender cancels $600 or more of debt, they are required to issue Form 1099-C, Cancellation of Debt, to both the borrower and the IRS. This form reports the amount of debt forgiven, which you must include as ordinary income on your tax return. However, certain exclusions may apply, preventing the canceled debt from being taxable. These can include insolvency, where your total liabilities exceed your total assets immediately before the debt is canceled, or if the debt is discharged in bankruptcy. Additionally, qualified principal residence indebtedness, which applies to certain debt forgiveness on your main home, can also exclude the canceled amount from income.

Maintaining comprehensive records is important for all aspects of a HELOC. For tax purposes, this includes keeping documentation that shows how the HELOC funds were used. Records such as receipts for materials, contractor invoices, and canceled checks can substantiate your claims. These records should be retained for as long as you own the home and for several years after the relevant tax returns are filed in case of an IRS audit. Proper record-keeping helps demonstrate compliance with tax laws and supports any deductions or exclusions you claim.