Do You Pay Taxes on a Home Equity Loan?

A home equity loan allows homeowners to borrow against the equity built in their property, using the home itself as collateral for the loan. Many homeowners consider these loans for various financial needs and often wonder about the tax implications. Understanding how these loans interact with federal tax laws is important for financial planning.

Tax Treatment of Home Equity Loan Principal

When you receive funds from a home equity loan, the principal amount you borrow is not considered taxable income. This is because the money received is a loan, which represents a debt you are obligated to repay, rather than earned income or a gain. The Internal Revenue Service (IRS) views loan proceeds as a transfer of funds that does not increase your net worth.

Deductibility of Home Equity Loan Interest

The interest paid on a home equity loan is tax-deductible only under specific conditions. For interest to be deductible, the loan proceeds must be used to buy, build, or substantially improve the home that secures the loan. This rule applies to loans taken out after December 15, 2017, as part of changes introduced by the Tax Cuts and Jobs Act (TCJA).

“Substantially improve” means making additions or improvements that add to the value of your home, prolong its useful life, or adapt it to new uses. Examples include adding a new room, replacing a roof, or installing a new heating and air conditioning system. Routine repairs or maintenance, such as repainting or fixing minor leaks, do not qualify as substantial improvements.

There are limits on the amount of debt for which interest can be deducted. For loans originated after December 15, 2017, the total amount of qualified residence debt is capped at $750,000 for married couples filing jointly. For married individuals filing separately, this limit is $375,000. This limit includes both your original mortgage and any home equity loans or lines of credit.

If the home equity loan proceeds are used for purposes other than buying, building, or substantially improving the secured home, the interest paid on that portion of the loan is not tax-deductible. For example, using a home equity loan to pay off credit card debt, fund college tuition, purchase a car, or finance a vacation would not qualify for an interest deduction. These rules apply to interest paid on loans secured by both a primary residence and a second home, provided both are considered qualified residences by the IRS.

Claiming the Interest Deduction

If you meet the eligibility criteria for deducting home equity loan interest, the process for claiming it involves specific tax forms. Your lender sends Form 1098 by the end of January each year. This form reports the amount of interest you paid on your mortgage, including qualifying home equity loans.

To claim the deduction, you must itemize deductions on your federal income tax return. The eligible interest amount from Form 1098 is reported on Schedule A. Your total itemized deductions must exceed your applicable standard deduction amount for itemizing to provide a tax benefit.