Is the Interest Paid on a Home Equity Loan Tax Deductible?

You must itemize deductions in order to take a home equity loan interest deduction.

Home equity loan interest may be tax deductible provided the loan meets certain conditions, according to Internal Revenue Service (IRS) Publication 936 for 2010, published at the IRS.gov website. Your ability to deduct the interest on a loan secured by your home's equity value will depend on the size of your loan and how you used the money.

Loan Size Limit

The tax code puts a dollar limit on the amount of home equity debt that qualifies for a mortgage interest deduction. That limit is the smaller of $100,000 or the difference (equity value) between your mortgage balance and the fair market value of your home, says the IRS' website. The IRS defines fair market value as the price at which a home would change hands between a willing seller and a willing buyer. The IRS suggests this price could be established by studying recent sales of similar homes in your area.

Loan's Purpose

Even though you borrow against your home's equity value, the proceeds may not be counted as home equity debt if you use the money to buy a second home or make "substantial" improvements to your home, says the IRS. A substantial improvement is one that adds to the value of your home, prolongs your home's useful life or adapts your home to new uses. Normal maintenance and repairs that maintain your home's value aren't considered substantial improvements.

Aquisition v. Equity Debt

Loan proceeds used to buy a home or make substantial home improvements are classified as home acquisition debt, which has a $1 million deductibility limit, rather than home equity debt with the $100,000 or equity value limit, says the IRS. Also, if you borrow against your home's equity value to buy out the ownership interest of a spouse or former spouse in a divorce settlement, the proceeds will be classified as acquisition debt rather than equity debt. Proceeds used for other purposes, such as college tuition or vehicle purchase, will be counted as home equity debt.

Another Deduction Path

If you borrow against your home's equity value but the loan doesn't qualify for a home mortgage deduction, you may still be able to take an interest deduction if you used the loan proceeds for investments or business purposes, says the IRS. The interest on your loan becomes an expense you can deduct from your investment or business income. If you use your loan proceeds for mixed purposes, such as building an addition to your house and buying a car, the IRS has worksheets for determining how much of the loan qualifies for the the mortgage interest deduction.

References

• IRS.gov: Publication 936, Mortgage Interest Deduction