While most interest expense is no longer tax deductible, it is a viable deduction if the interest is on your primary or secondary residence. While limits apply, the use of a secondary loan on your primary or secondary residence can also qualify for interest deductibility. However, “home equity” loan interest can often lose its tax deductibility if you're not careful. Here is what you need to know.
Home Acquisition or Home Equity Debt?
The first thing to understand is whether the debt secured by your residence is considered "Home Acquisition Debt" or "Home Equity Debt" per the IRS.
Home Acquisition Debt: Home Acquisition Debt is debt used to purchase, or refinance a primary or secondary residence. It also includes debt used to substantially improve your property. Interest deductibility of this type of debt is limited to the fair market value of the property or a total Acquisition Debt limit of $1 million ($500,000 if married filing separately). The interest expense is deducted as an itemized deduction on Schedule A of your 1040.
Home Equity Debt: Home Equity Debt is all other debt secured by your primary or secondary residence. Interest deductibility of this type of debt is limited to the fair market value of the property taken in conjunction with Home Acquisition Debt. In addition, home equity interest deductibility is limited to Home Equity Debt of $100,000 ($50,000 if married filing separate).
The Many Uses of Home Equity Debt
Because interest on home equity loans can be tax deductible as an itemized deduction, many see this as the preferred method of borrowing. Common uses of home equity:
- Consolidating credit card debt
- Financing college costs
- Starting a business
- Buying a car, boat or other major vehicle
- Funding medical procedures
- Home improvements and maintenance
Home Equity Debt Pitfalls
If you are counting on using your Home Equity Loan interest as a tax deduction you will want to make sure you understand the pitfalls. All too often home equity loans and their related interest become a problem when:
- The loan interest is disallowed because it is not secured by a main or second home.
- The outstanding loan balance exceeds the fair market value of your house. This includes your original Acquisition Debt plus your Home Equity Debt. When this occurs there is no longer equity to support the loan. Best case; you lose interest deductibility on your tax return. Worst case; your bank demands repayment of your home equity loan because your home no longer provides adequate collateral.
- You decide to use your home as a home office or as rental property. In this case the interest becomes a business expense, not an itemized deduction.
- The Home Equity Debt exceeds $100,000 ($50,000 if married filing separately) or total Acquisition Debt exceeds $1 million ($500,000 if married filing separate).
- You consolidate your credit card debt into a home equity loan, continue building your credit card debt and then default on your payments.
- You refinance to pull out equity. This not only creates additional leverage on your property, it could cause you to surpass the home equity debt limit AND require the need to purchase mortgage loan insurance.
While Home Equity Debt can provide a valuable tax deduction, you must stay vigilant to the rules and understand your situation. Remember a default on a credit card doesn't necessarily risk losing your home, a default on your home equity loan could put you on the street.