Borrowing Against Your Home Equity Has Tax Benefits and Pitfalls

If you need funds to cover a purchase, pay off debt or remodel your home, you have a few lending options—including the use of home equity.

You could use your credit card to cover the cost or take out a personal loan from the bank. You also can use the equity in your home to open a home equity line of credit (HELOC) or get a home equity loan.

All of these options will get you the funds you need now, but only two have tax perks: both a home equity loan and a HELOC come with tax deductions.

But be forewarned––there are caps and potential exclusions to these tax benefits.

Home Equity Options

With a home equity loan, you’ll receive one lump sum and make fixed monthly payments. With a HELOC, you’ll have an open-ended credit line you can draw from again and again as long as you’re making payments—and your credit limit is not maxed out.

Both home equity loans and HELOCs can be used for any need you have. Both also typically offer lower interest rates than a standard credit card.

Tax Deductions

Unlike other forms of borrowing, both home equity loans and HELOCs have the added bonus of tax deductions, if you’ve paid interest toward the loan.

“If you have $100,000 loan at 10% interest, you would be paying about $830 every month in mortgage interest,” said David Reischer, a business attorney and co-founder of LegalAdvice.com. “That amount over the course of a fiscal year would be potentially deductible at the end of the year when you file.”

But there is a cap to how much you can deduct: the mortgage interest can only be deducted for a loan amount limit up to $1,000,000. And if you choose to use the money for something other than reinvesting into your home, you’ll face another limit.

“The interest is further capped at $100,000 for the proceeds of a loan that are not used for home improvement or other housing expenses, but are used for some other purpose like credit card consolidation, paying for education expenses or other non-housing related expense,” Reischer said.

Potential Pitfalls

Tax deductions are often like a double-edged sword. While many people are able to take the full deduction, other people may end up taking a reduced amount.

For example, if you’re a high-income earner, you may be subject to Alternative Minimum Tax, which Resicher notes may affect whether you will still need to pay tax on mortgage interest.

Certain benefits–like an interest deduction for a home equity loan or HELOC–can significantly reduce the amount of taxes a person owes.

According to the Internal Revenue Service, “the AMT sets a limit on those benefits. If the tax benefits would reduce total tax below the AMT limit, the taxpayer must pay the higher Alternative Minimum Tax amount.”

Determining Your Tax Benefits

To make sure you’re filing correctly—and getting the full deduction you’re allowed—gather your paperwork and consider seeing a tax specialist.

You’ll need documentation for your original mortgage as well as documentation for your loan. You’ll also need a statement from your mortgage servicer that details the amount of mortgage interest paid in the fiscal year, Resicher said, which are typically issued annually by mail.

Lastly, to determine if you’re subject to the AMT, you’ll also need proof of your income and assets.