The home mortgage interest deduction allows homeowners to deduct the interest they pay on a home equity loan, which is a type of loan that uses equity in your home as collateral.
As a result of the Tax Cuts and Jobs Act enacted in 2017, the deduction works differently in tax years 2018 and beyond than in years prior. However, if you use the proceeds of the loan for what the IRS deems to be "substantial improvements" to your home, and meet other criteria, home equity loan interest may still be deductible to an extent. Understanding the potential and limits of the mortgage interest deduction can help you properly deduct home equity loan interest and reduce your tax bill.
Basics of the Mortgage Interest Deduction
A mortgage can help you buy a home or borrow against a property you already own in the case of a home equity loan. It might even provide some tax benefits since the interest you pay is sometimes deductible.
Under the home mortgage interest deduction, the IRS allows you to deduct the interest you pay on any loan secured by your main home or a second home, including:
- Purchase loans (your primary mortgage when you borrow money to buy a house)
- Home equity loans (often used as a second mortgage), which provide a lump sum of cash up front
- Home equity lines of credit, which allow you to spend from a credit line
A home equity loan can help you fund home improvements or pay down debt. Deducting home equity loan interest can potentially make the loan for these purposes less expensive and turbo-charge strategies like debt consolidation. Suddenly, the interest you pay becomes tax-deductible and is no longer just an expense.
When You Can Deduct Home Equity Loan Interest
Mortgage interest on a home equity loan is generally only tax-deductible when you meet certain conditions:
- First or second home: The home mortgage interest deduction isn't for investors who own dozens of homes. To qualify, the loan must be for your first or second home. If you rent out a property, share it, or use it as an office, your deduction will be limited.
- Loan criteria: Your loan must be secured by your first or second home. This generally means your lender has a lien on your home and can foreclose if you fail to pay.
- Substantial improvements: In tax years 2018 until 2026, home equity loan interest is only deductible if you use the loan proceeds to "buy, build, or substantially improve" the home that secures the loan. This means that you could take the mortgage interest deduction for a home equity loan you use to add a room to your home but can't take it if you use the loan proceeds to pay off credit card debt, for example. This restriction did not apply in 2017 and prior.
- Arm's length standard: The IRS states that “both you and the lender must intend that the loan be repaid.” This eliminates schemes such as using a sham transaction to save on taxes. For example, you can’t “borrow” from a family member, deduct the interest, and forget about the loan; the loan must function as a true arm’s length transaction.
- Construction loan: If you’re building a first or second home, you can still treat it as a qualified home for 24 months and take the mortgage interest deduction if it becomes a qualified home after construction is completed.
As of tax year 2018, you can't deduct home equity loan interest or other types of mortgage interest if you don't use the loan proceeds to buy, build, or substantially improve your home.
Limits When Deducting Home Equity Loan Interest
Don’t rush to take out a loan just for savings at tax time. There are maximums and other limitations that might reduce or completely eliminate your ability to deduct the interest. The home mortgage interest deduction is restricted in several ways:
- Dollar amount: Generally, the dollar limit for the mortgage interest deduction is lower for loans taken out in 2018 and afterward but is always higher when you use the loan proceeds for your home. If you use the money for another purpose (like higher education or debt consolidation), your deduction will be limited. The mortgage interest you pay is fully deductible if you meet at least one of the following criteria. Otherwise, your deduction is limited to the amount of mortgage interest up to your qualified loan limit, which you can calculate using Table 1 in Publication 936.
- The debt is from October 13, 1987 or before (known as “grandfathered” debt)
- The debt was taken out after October 13, 1987 but before December 16, 2017 and was used to buy, build, or improve your home, and the total amount of debt (not interest) throughout 2019 was $1 million or less
- The debt was taken out after December 16, 2017 and was used to buy, build, or improve your home, and the total amount of debt throughout 2019 was $750,000 or less
- Itemizing deductions: The mortgage interest deduction is only available if you itemize your deductions, which many people don’t do. If you’re not sure whether you itemize, see if you’ve filed Schedule A of Form 1040. It’s typically best to take the largest deduction available; if your standard deduction is considerably more than you’d get from itemizing, itemizing for the sake of deducting mortgage interest costs might not offer any tax benefits. To get more than your standard deduction, you might need a sizable loan or other expenses to help (such as high medical expenses, for example).
- Deduction vs. credit: Some people confuse tax deductions with tax credits. A deduction helps to lower the amount of income used to calculate your taxes due. A credit is a dollar-for-dollar reduction in what you owe. The mortgage interest deduction will indirectly reduce your tax bill, but it isn’t nearly as powerful as a tax credit.
If you’ve borrowed against the equity in your home, and you want to know how much interest you’ve paid so that you can deduct it, ask your lender. You should receive Form 1098 with details about the home equity loan interest you paid for the year.
The Bottom Line
Under the home mortgage interest deduction, home equity loan interest is deductible in certain cases. However, the requirement to use the proceeds for these loans for the home severely limits its potential in 2018 and beyond. The restriction highlights the importance of getting home equity loans and other mortgages only if you need them—not to save money in deductions. Deductions don't reduce your tax bill by as much as a tax credit in any case.
However, taxpayers with grandfathered debt or with loans used for home improvements and falling within the loan size limit may still stand to gain from the mortgage interest deduction. Claiming the mortgage interest deduction improperly can lead to tax penalties from the IRS, so verify all of the details about your situation by reading IRS Publication 936.
Remember: Tax laws frequently change. Speaking with a tax preparer who is familiar with the details of your home equity loan can help you avoid any problems when taking the deduction.