Wed, Nov 21, 2018
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Using home equity to pay for your next home improvement project or cover college expenses is a great way to get the money you need at low interest rates. But, the benefits of a home equity loan extends well beyond a quick buck.
In fact, just like your original mortgage, the interest on a home equity loan is tax deductible. And that could mean big tax savings for you.
According to the U.S. Treasury Department the mortgage interest deduction costs the government about $100 billion in lost tax revenue each year. Deducting home equity loan interest on your taxes could save you thousands over the life of the loan in addition to your standard mortgage interest deduction.
But wait - there’s a catch!
A dollar is a dollar, right? Not according to the IRS. How you use the cash from a home equity loan will affect how much of the interest is tax deductible.
Before you deduct all of the interest from your home equity loan on your taxes this year keep in mind there are certain restrictions. For example, if you use your home equity to consolidate your debt or pay for your children’s college expenses you may not be able to deduct all of the interest.
On the other hand, if you use this money to make substantial home improvements or purchase a second home, the limits are much higher.
A home equity loan can be used for almost anything, but there are certain uses that are more popular than others. Many homeowners choose to take out a home equity loan to consolidate their credit card or personal debt into one low interest loan. Since the loan is secured against the home, interest rates are much lower when compared to other unsecured loan alternatives.
The benefit is that they save money on interest charges and they have only one bill to pay each month.
Alternatively, many homeowners use their home equity to pay for college expenses when student loans don’t cover the cost of tuition.
No matter how you use your home equity loan for non-home related purchases, there are strict limits on the interest tax deductions. According to the IRS Publication 936, homeowners can deduct interest paid on the first $100,000 or a maximum of the fair market home value after subtracting home acquisition and grandfathered debt. The tax deduction is limited to the smaller of the two.
As you can see, it starts to get complicated real fast. Need an example? Here’s one straight from the horse’s mouth (IRS Publication 936):
“You own one home that you bought in 2000. Its Fair Market Value (FMV) now is $110,000, and the current balance on your original mortgage (home acquisition debt) is $95,000. Bank M offers you a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or other liens. To consolidate some of your other debts, you take out a $42,500 home mortgage loan [(125% × $110,000) ? $95,000] with Bank M.”
Your home equity debt is limited to $15,000.
This is the smaller of:
$100,000, the maximum limit, or
$15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000
Interest on amounts over the home equity debt limit (such as the interest on $27,500 [$42,500 ? $15,000] in the preceding example) generally is treated as personal interest and is not deductible.
If you use a home equity loan to make substantial improvements to your home you can deduct the interest on up to $1 million worth of mortgage debt.
So you might be wondering what does substantial improvement mean? The IRS considers a home improvement to be substantial if it:
Adds to the value of your home,
Prolongs your home’s useful life, or
Adapts your home to new uses
It is important to note that normal maintenance repairs that keep your home in good condition are not considered substantial improvements. For instance, the cost of repainting your home would not qualify as an improvement. However, if during your kitchen remodel you were forced to repaint your home, you could include the painting costs in the cost of the improvements.
Repairs that maintain your home in good condition, such as repainting your home, are not substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.
This is obviously tricky territory when determining which aspects of a home improvement project can be included in the overall costs. Which leads us to our final point: Always consult a tax professional.
It should go without saying that you will need to consult a tax professional with any questions about whether home equity loan interest is tax deductible or not.
Whether you plan to use a home equity loan to cover non-home related purchases or to completely remodel your house, the tax code can be tricky. However, there are serious financial benefits available to those that take the time to understand their tax deduction options and work with a tax professional.
At the end of the day, smart tax planning will mean more money in your pocket.
If you’re looking for home equity loan alternatives to consolidate debt or remodel your home, consider reading our guide on peer to peer lending. You may be able to qualify for a loan with no money down and at a competitive interest rate.