Taxes And Your Home Equity Loan

For many householders, the house they own is not merely a shelter, but serves the purpose of a privately owned bank.

If structured correctly, you can get a substantial tax deduction by the money you are allowed to draw on your home’s equity. Generally, most homeowners can deduct up to $100,000 on their ‘home equity line of credit’ or HELOC.

However, there are some limits on deductibility. The benefits could also be negated by the ‘alternative minimum tax’ or AMT. Hence, homeowners need to make an overall estimate of their financial requirements and the state of affairs of their taxes.

The funds accrued from home equity are usually utilized to pay for things like remodeling, renovating or making improvements to the home, paying for children’s college tuitions, or for consolidating the debt on credit cards or personal loans. A homeowner can get larger amounts of money to spend on these, by leveraging the investment already made on the house.

Plus, there is the tax benefit, of course. According to the tax law, irrespective of the way the money is spent, borrowers can deduct an interest of up to $100,000 on a loan made on home equity, or by combining a number of loans.

However, whether this amount can really be deducted, and precisely what amount of interest on a loan made on home equity is deductible is determined by various factors.

Usually, homeowners train their sights on the amount of $100,000 which ads based on home equity tout as deductible. However, borrowers should also be cognizant about how the actual market value of their property along with any existent mortgage can effect their tax deductions.

When all the loans taken on a home are combined, which includes the initial mortgage along with other equity loans, add up to more than the actual market value of the property, there is no deduction of the interest on that part of the debt that is more than the value of the home.

For instance, if the mortgage of your home is $95,000, and your house is currently worth $110,000, your bank will tell you that you can avail of 125 percent of the loan-to-value loan on equity, which amounts to $42,000. Since that amount is less than the $100,000 limit, you take up the offer, planning on deducting the interest of the equity loan on the taxes you have, to pay for your daughter’s outstanding tuition bills and for a vehicle for her to travel back and forth from college. In such circumstances, however, according to tax rules you can either deduct the interest on loans made on equity that amount to $100,000, or if the combined amount of loans taken on a home equals more than its actual value in the market – whichever is the lower amount. In the example given here, that would be $15,000, which is the amount when you minus $95,000 from $110,000. This means you get a tax break on the interest that accrues from just $15,000 on your home equity loan. The interest on the rest of the equity loan amount, which is $27,000, cannot be deducted, although it has been taken on your home and is less than the $100,000 limit.

However, when a loan made on equity is utilized for making improvements on the home, it is taxed differently. In such a case, the equity funds are treated like initial mortgages. This is termed as ‘acquisition indebtedness’, according to IRS terminology. On such loans, the interest on an amount of up to $1 million in mortgage debt can be deducted.

Those who take loans on home equity should also be aware of the implications of alternative minimum tax amounts. This taxing system may cost them their tax deduction.
Plus, under the AMT, the interest that is applicable to acquisition debt loans remains deductible. But the money that you secure from your home has to be spent on it, and not used for other purposes. Also, the IRS will ask you to pay back any home equity loan interest that it finds you have claimed inaccurately, along with charging an interest on it and a penalty.

It also has to be kept in mind that although the amount of a home equity loan may be comparatively small, it is still secured by your home. The bank will want to be repaid, and your home is the collateral it holds. Thus if you are unable to pay back the debt, you could have to move out.