One of the main concerns people have about home equity loans has to do with how they are affected by tax policy. Specifically, what are the rules when it comes taxation and taking a deduction for the home equity loan interest that you pay? Franklin closeup2

Generally speaking, interest on home equity loans is tax-deductible, as is the interest paid on the primary mortgage you used to buy your home. However, there are some significant differences worth noting.

Not taxable as income

There are two other tax matters to get out of the way before we talk about deductions, though. First, the funds you receive through a home equity loan or home equity line of credit (HELOC) are not taxable as income - it's borrowed money, not an increase your earnings.

Second, in some areas you may have to pay a mortgage recording tax when you take out a home equity loan. This may be assessed by your state, county or municipality and are based on the loan amount. So the more you borrow, the higher the tax. They're fairly uncommon though, and found in only a few states.

Guidelines for home equity loan tax deductions

The standard rule is that a couple can deduct the interest paid on up to $100,000 in home equity loan debt and a single filer can deduct the interest on up to $50,000.  So if a couple has a $100,000 home equity loan and paid $7,000 in interest on it over the course of the year, they can take a $7,000 deduction on their joint tax return.

That's going to cover most home equity borrowers. But there's an added wrinkle that can raise those limits depending on how you use the money.

The IRS allows couples filing jointly to deduct the interest on home loans for up to $1 million in home acquisition debt, and up to $500,000 for single filers. Most of the time, that's going to be the deduction for the primary mortgage used to purchase the home.

However, the IRS defines home acquisition debt as debt used to "buy, build or improve" a home. So if you take out a home equity loan and use it for home repairs or improvements, it's considered home acquisition debt and subject to the higher $1 million/$500,000 limits.

So if a single filer were to take out a $75,000 HELOC and use it to build an addition onto his home, he could deduct the home equity loan interest paid on the entire $75,000. But if he were to use it to buy a boat or pay for his daughter's college expenses, he could only deduct the interest paid on the first $50,000 of the amount.

The rules treat home acquisition and home equity debt separately, so a couple can deduct the interest paid on up to $1 million in home acquisition debt plus another $100,000 in home equity debt, for a maximum of $1.1 million combined. For single filers, the maximum would be $550,000.

Deducting interest paid on a second home

Another important angle is that you can deduct the interest on home loans up to two properties. You're still subject to the same overall limits, but your total allowance can be split between a primary and secondary residence.

So if a couple has a $750,000 mortgage on their main residence, a $250,000 mortgage on a vacation home, they'd still be under their $1 million maximum and could deduct all the interest paid on those debts. Likewise, if they also had a $60,000 standard home equity loan on the first and a $40,000 HELOC on the second, they could deduct all the interest paid on those as well.

To qualify, both homes must be for your personal use. If you rent out the second part time, you must use it yourself at least 14 days a year or 10 percent of the total time rented out, whichever is greater, or it will be considered rental property and ineligible for the mortgage interest deduction.

Business deduction

There's yet another option if you use the proceeds from a home equity loan to start or operate a business, buy a rental property, or for some other type of investment. In that case, the interest you pay may be deductible as an investment/business expense, and different rules would apply.

Talk to your tax preparer

These are just general guidelines.  Different rules may apply to your specific situation and various circumstances can complicate the picture. Talk with your accountant or other tax professional before making any decisions on a home equity loan based on tax ramifications, or before claiming deductions on your tax returns.

Published on May 15, 2006