The Tax Benefits of Home Equity Lines of Credit (HELOC)

The tax benefits of home equity lines of credit, or HELOCs, are very similar to that of first mortgages. Yet there are  differences in regard to the use of the proceeds that come from a HELOC. It’s important to know those differences if you’re considering taking a HELOC, particularly one that you get after you have purchased your home.

Using a HELOC to Purchase Your Home
Many buyers use a HELOC as a way of avoiding private mortgage insurance (PMI). PMI is triggered by making a small down payment on the purchase of home. As a general rule, any time you make a down payment that is less than 20% of the purchase price of the home, you may have to pay PMI. It’s not cheap either; you can easily pay a couple hundred dollars per month even on a moderately sized mortgage of $250,000.

To avoid this, buyers may try a first/second mortgage combination. You take a first mortgage equal to 80% of the purchase price, so that PMI will not be required. The remaining 20% is provided by a combination of a second mortgage or a HELOC, and the actual amount of the down payment.

A popular combination is what is referred to as an “80-10-10”, comprised of an 80% first mortgage, a 10% HELOC, and a 10% cash down payment. That cuts the down payment amount in half, and removes the PMI requirement.

Fortunately, the tax considerations for interest a on a HELOC used to purchase your home are virtually identical to those for your primary mortgage. As long as the HELOC is used to purchase the home, the interest will be fully deductible.

The IRS allows you to fully deduct mortgage interest paid on a total acquisition debt of up to $1 million, or $500,000 if you are married filing separately. As long as your first-second combination mortgage arrangement is within these dollar limits, you can deduct all of the interest that you pay on both the first mortgage and on the HELOC.

Using a HELOC to Make Improvements to Your Home
The tax-deductibility of HELOC interest is similar to when other money is borrowed to make improvements to your home. This can include major repairs and renovations, such as replacing the roof, carpeting, or components, such as the furnace, central air conditioner or hot water heater.

Interest is also fully deductible if the money is used to make major improvements. This can include renovating the kitchen and bathrooms, finishing the basement, or putting an addition on the house.

In all of the above cases, the interest that you pay on the HELOC will be fully tax-deductible. Limitations apply when money is borrowed that is not used in connection with either purchasing or improving the home.

Using a HELOC for Purposes Unrelated to Your Home
This is where the HELOC interest may not be tax deductible. Under IRS rules, you can only deduct interest paid on a HELOC up to a loan amount of $100,000 ($50,000 if you are married filing separately) if the money is used for purposes not related to the home.

This is an extremely popular way that people take HELOCs in the first place. For example, they may borrow the money for solid financial reasons, such as consolidating high interest rate credit card debt, or helping to pay for their children’s college education. But sometimes the purpose of the loan is not so solid, such as using the money to purchase a new car, or paying for a wedding or a vacation trip to an exotic location.

While you can still deduct interest on a HELOC balance of up to $100,000, it isn’t necessarily a good financing pattern to get into. The problem is that once you take a HELOC for purposes unrelated to your house, the temptation will be to do it again. That’s when the HELOC becomes a true revolving line of credit secured by the home. And it’s easier than you might think to exceed the $100,000 limit, after which interest paid on additional borrowed funds will no longer be tax-deductible.

This is particularly true in regard to using a HELOC as a debt consolidation loan for high interest credit card debt. Since the HELOC essentially transfers the credit card debt to a different loan type, that frees up the credit card limits to be spent again. Serial debt consolidation using your HELOC could result in a non-deductible interest situation.

A HELOC can provide greater flexibility in regard to either purchasing or improving your home. But if you’re going to use it for unrelated purposes, make sure you’re fully familiar with the tax benefits of doing so.

If you took out a HELOC loan, TurboTax will ask you simple questions about your loan and give you the tax deduction you are eligible for.