One benefit of home equity loans and home equity lines of credit (HELOC) over other loan options is that the interest paid on them is tax-deductible in some cases. You can deduct the interest paid on your home equity loans from your taxes. For example, when you take HELOC or home equity loan under some specific conditions i.e. spending home equity loan to buy, build or renovate your home, then the interest from your federal taxes would be deductible.
In other cases, when you get a loan from a credit card, you pay a higher cost of interest that can\’t guarantee you a deduction for your taxes.
Home Equity Loans And HELOCs For 2020
The amount of deduction includes the home equity loan/HELOC, interest you pay on your mortgage or mortgage refinance. In earlier 2018, there was no knowledge that the interest paid on home equity loans or HELOC is tax-deductible.
In December 2017, Congress passed a new law “Tax Cut and Jobs Act”. Which changed the way the IRS and homeowners to consider home equity loans and HELOCs. So, if you get a home equity loan or HELOC to merge debt, buy a car, pay for medical expenses, college, vacations or pay off the credit card debt. In these conditions, the interest is no longer tax-deductible.
The changes under the new law apply to the tax years between 2018 and 2026. In these years, interest must be deducted from taxes on HELOC and home equity loans if you guarantee the IRS to use the funds to buy, build or substantially renovate your home.
For example, you can deduct the interest if you use the loan to renovate your kitchen, making an additional portion in your home or replace the roof.
In 2018, Under the new law, Congress reduced the interest limit to taxpayers. These new limits on the amount of interest a borrower can claim are the following:
- If you purchased a home on the debt before 16 December 2017, you can deduct up to $1 million from the interest on loans for married couples that filed jointly and $500,000 for those married couples which filed separately.
- if you purchased a home on the debt after Dec. 16, 2017. Married couples who filed jointly can deduct interest up to $750,000 on loans and those couples who filed separately can deduct interest $375,000 for any home for a qualified residence.
A qualified residence refers to the house where you live i.e. primary residence. Besides your primary residence, you can claim mortgage-related tax benefits as long as you don\’t earn income from your second home.
How the interest deduction from Tax on home equity loans and HELOC works?
The following example can help borrowers to understand how the interest deduction from Tax on home equity loans and HELOC works:
Consider a situation in which your household has a taxable income of $100,000 per year. You want to borrow the money to cover the cost of renovating your kitchen. Instead of getting a home equity loan you deposit the money in your credit card and pay 30% annual interest.
It has a marginal tax rate of 35% and cannot deduct the interest from your taxes on your credit card. Your after-tax income will be $65,000.
$100,000 × 0.35 = $35,000
Now consider another situation, where you get a home equity loan at a rate of 10% instead of depositing money in your credit card. You can deduct the interest paid from your taxable income on the home equity loan.
If you borrow $30,000, you will pay approximately $3,000 as interest during the year ($30,000 × 0.10 = $3,000). This reduces your taxable income to $97,000. Your after-tax income will be $63,050 for annual tax savings of $1950.
$97,000 × 0.35 = $33,950
On the surface, Tax savings may not seem significant. However, you should consider that savings increases as the loan amount, the interest rate of the loan, or the marginal tax rate increases. In addition, the effective cost of the loans with a secured mortgage or home equity loan is much lower than the cost of loans with credit cards and personal loans.