The interest on a home equity loan is tax-deductible, provided the funds were used to buy or build a home, or make improvements to one, as defined by the IRS.
Home equity loan interest, as well as home equity line of credit (HELOC) interest, can be written off your income taxes when you use the money for home improvement purposes, or to purchase or build a new home. You must also itemize your deductions to write off the interest you paid.
Home equity can be taxed when you sell your property. If you're selling your primary residence, you may be able to exclude up to $500,000 of the gain when you sell your house. Home equity loans, home equity lines of credit (HELOCs), and refinancing all allow you to access your equity without needing to pay taxes.
Before tax time, you should receive an IRS Form 1098, or Mortgage Interest Statement, from your lender or lenders. It shows the interest you paid on your primary mortgage, home equity loan or HELOC in the previous year. You'll need this form if you want to deduct the interest on your home equity loan or line of credit.
The bottom line
If you want to take a home equity loan tax deduction on your 2023 tax return, you'll need to open the loan before the deadline. Remember, though, that you can deduct interest payments as long as the money is used to improve the home used to take out the loan.
According to the Internal Revenue Service (IRS), mortgage interest on a home equity loan is tax deductible as long as the borrower uses the money to buy, build or improve a home.
The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes. Otherwise, it is considered personal interest and isn't deductible.
The Bottom Line
Home equity loans can be a great way to improve your home, consolidate debt, pay for student loans or help alleviate other financial strains on your budget.
However, if you've used home equity financing, the amount you borrowed will need to be repaid from the proceeds of the sale before calculating any capital gains. This means that the amount you can exclude from capital gains may be reduced or eliminated altogether.
Though personal loans are not tax-deductible, other types of loans are. Interest paid on mortgages, student loans, and business loans often can be deducted on your annual taxes, effectively reducing your taxable income for the year.
What triggers taxes on equity? Two taxes generally apply to employee equity earnings: ordinary income tax and capital gains tax. Typically, you'll owe income tax on your equity in the tax years during which you acquire shares. Capital gains tax comes into play when you sell your shares.
When selling a primary residence property, capital gains from the sale can be deducted from the seller's owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale. That is the 2-out-of-5-years rule, in short.
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married and filing jointly. The exemption is only available once every two years.
Though taking out a home equity loan can cause your credit score to drop, the impact is usually fairly small, and you can improve your score over time by managing your credit responsibly.
Here's how it works: Taxpayers can claim a full capital gains tax exemption for their principal place of residence (PPOR). They also can claim this exemption for up to six years if they moved out of their PPOR and then rented it out.
Current tax law does not allow you to take a capital gains tax break based on age. In the past, the IRS granted people over the age of 55 a tax exemption for home sales. However, this exclusion was eliminated in 1997 in favor of the expanded exemption for all homeowners.
Before tax time, you should receive an IRS Form 1098 (Mortgage Interest Statement) from your lender or lenders. This form will show the interest you paid on your primary mortgage, home equity loan, or home equity line of credit in the previous year. Contact your lender if you haven't received it.
Home Equity Loan Disadvantages
Higher Interest Rate Than a HELOC: Home equity loans tend to have a higher interest rate than home equity lines of credit, so you may pay more interest over the life of the loan. Your Home Will Be Used As Collateral: Failure to make on-time monthly payments will hurt your credit score.
Loan payment example: on a $50,000 loan for 120 months at 8.40% interest rate, monthly payments would be $617.26. Payment example does not include amounts for taxes and insurance premiums.
Both home equity loans and HELOCs are secured by borrowing against your home equity, which means your home acts as collateral for the loan. This is hugely significant because if you default on the loan, your bank or lender can repossess the property.
In general, you can deduct the mortgage interest you paid during the tax year on the first $750,000 of your mortgage debt for your primary home or a second home. If you are married filing separately, the limit drops to $375,000.
If the loan is not a secured debt on your home, it is considered a personal loan, and the interest you pay usually isn't deductible. Your home mortgage must be secured by your main home or a second home.
For 2023, the standard deduction increased to $27,700 for married couples filing jointly, up from $25,900 in 2022. Single filers may claim $13,850 for 2023, an increase from $12,950. Enacted via the Tax Cuts and Jobs Act of 2017, the higher standard deduction is slated to sunset in 2026, along with lower tax rates.
Borrowers often wonder if they can pay off their home equity line of credit (HELOC) early. The short answer? A resounding yes, because doing so has many benefits. If you're making regular payments on your HELOC, you may be able to pay off your debt sooner, so you're paying less interest over the life of the loan.
You can refinance a home equity loan by replacing it with a new home equity loan or a new home equity line of credit (HELOC) or refinancing into a new, larger first mortgage. If you don't qualify to refinance your home equity loan, a loan modification could be an option.