Taking out a home equity loan can put a few extra dollars in your pocket come tax time. While you can benefit from loan-related tax deductions, whether the mortgage interest you pay is fully deductible depends on why you borrow the money.
If you use the money for reasons other than making improvements to your home or buying a second home, there are limits on how much of the interest you can deduct on your federal income tax.
Deduction Limits for Home Improvements
If you take out a home equity loan to make home improvements and file your tax return as single or married filing jointly, you can deduct the interest on up to $1 million of the combined amounts you’ve borrowed. You can’t deduct interest you pay on any amount that exceeds the $1 million loan limit.
For example, if all the loans that qualify for the mortgage interest deduction total $1.1 million, you can’t claim the interest you pay on the additional $100,000 loan amount, even if you use the money to make home improvements.
The most interest you can deduct is $500,000 if you are married but file a separate tax return.
Deduction Limits When You Don’t Make Home Improvements
If you don’t take out a home equity loan to make major home improvements, buy another home, or build a home, you can only deduct the interest you pay on the first $100,000 you borrow. In other words, if you borrow the money to go on a Caribbean cruise, the tax break you get will be smaller.
If you and your spouse file separate returns, you can each deduct the interest on the first $50,000, but you both have to itemize your deductions.
Your Home as Collateral
You can’t deduct the interest you pay on a home equity loan as mortgage interest expense unless you put up your home as collateral.
The total for all your mortgage debt can’t be more than your home’s fair market value when you take out the loan. Your home’s fair market value is the price you would expect to get if you sold it at the time.
You must itemize deductions on Form 1040, Schedule A of your tax return to deduct interest you pay on your home equity loan. Whether you can claim mortgage interest as an itemized expense depends on whether you exceed the standard deduction you can take for your filing status.
Even if you didn’t itemize in previous tax years, the interest you pay on a home equity loan may be enough to put you over the standard deduction. Form 1098 that you get from your lender shows the amount of interest you paid on the loan during the tax year.
If you use any part of your home as a home office, the IRS only allows you to deduct the amount of interest you pay for the part of the home you live in.
You may be able to deduct the remaining portion of the mortgage-interest expense for the business use of your home on Form 1040, Schedule C — Profit or Loss from Business. Contact a company like Capital Accounting And Tax Service Inc for more information.