What Is Home Equity Indebtedness for Tax Purposes?
Understand the tax rules for home equity indebtedness. The deductibility of your interest depends entirely on how you use the loan funds, not the loan's label.
Home equity indebtedness is a loan secured by a taxpayer’s qualified home, where the funds are not used to buy, build, or substantially improve that property. It allows homeowners to borrow against their equity through a lump-sum loan or a home equity line of credit (HELOC). Because the residence serves as collateral, these loans often have more favorable interest rates than unsecured debt. The defining characteristic is that the funds are used for personal expenses rather than for improving the home that secures the loan.
Defining Qualified Loan Limits
For tax purposes, mortgage debt is separated into two categories. The first is “home acquisition indebtedness,” which is debt incurred to buy, build, or substantially improve a qualified residence and must be secured by the home itself. The total amount that can be treated as home acquisition debt is limited to $750,000 for married couples filing jointly or $375,000 for those married filing separately.
The second category is “home equity indebtedness,” defined as any debt secured by a qualified residence that is not home acquisition debt. Historically, this type of debt had a separate limit of $100,000, or $50,000 for a married individual filing a separate return. This limit was in addition to the cap on acquisition debt.
A “qualified residence” is a component in these definitions. A taxpayer can have two qualified residences: their main home and one other home. A boat or recreational vehicle can qualify as a second home as long as it has sleeping, cooking, and toilet facilities. The debt must be secured by one of these two qualified residences to be considered under these rules.
Tax Deductibility of Interest
The Tax Cuts and Jobs Act (TCJA) of 2017 suspended the deduction for interest on home equity indebtedness for tax years 2018 through 2025. If loan proceeds are used for personal expenses, like paying off credit card debt, the interest is not deductible. This suspension applies to both new and existing home equity loans.
An exception to this suspension exists. If funds from a home equity loan, HELOC, or a cash-out refinance are used to buy, build, or substantially improve the home that secures the loan, the interest may be deductible. In this scenario, the debt is treated as home acquisition debt for tax purposes. The name of the loan is less important than how the proceeds are used.
For instance, if a homeowner takes out a $50,000 HELOC and uses the entire amount to remodel their kitchen, the interest on that loan is deductible. The debt is considered home acquisition debt because it was used to substantially improve the residence.
Conversely, if that same $50,000 HELOC was used to purchase a car or pay for college tuition, the interest would not be deductible. The use of the funds for non-qualifying purposes means the debt retains its character as home equity indebtedness for tax purposes. After 2025, the previous rules are scheduled to return, which would restore the deduction for interest on up to $100,000 of home equity debt.
Calculating and Reporting Deductible Interest
To claim a deduction for interest that qualifies as home acquisition debt, a taxpayer must prove how the funds were used by applying IRS “tracing rules.” These rules connect the debt to the specific expenditure, which determines the tax treatment of the interest. The destination of the funds, not the property securing the loan, is what matters.
Meticulous record-keeping is required. Taxpayers should retain documents related to the use of loan proceeds, such as contractor invoices, canceled checks, and receipts for building materials. These records serve as proof that the funds were used for qualifying home improvements, construction, or purchase costs, which is needed to substantiate the deduction if questioned by the IRS.
Lenders issue Form 1098, Mortgage Interest Statement, which reports the total interest a homeowner paid during the year. This form does not distinguish between deductible and non-deductible interest based on the use of funds. The taxpayer is responsible for calculating the portion of the reported interest that is deductible.
The final calculation is reported on Schedule A (Form 1040), Itemized Deductions. A taxpayer must itemize deductions to claim this benefit, rather than taking the standard deduction. If only a portion of a loan’s interest is deductible, the taxpayer must calculate the qualifying amount and report it on Schedule A, potentially attaching a statement to explain any difference from Form 1098.