If you own a home and take out a home equity loan, the IRS allows you to deduct some of your interest payments. However, the agency limits your deduction to the interest that accrues on a maximum loan balance that is equal to the lower of $100,000 or the equity you have in your home. You must also insure that the loan satisfies other IRS requirements before deducting the interest.
1. Make sure that the loan is secured by a qualified home. The IRS only allows you to deduct home equity loan interest if the line of credit you obtain is secured by a qualified home. All taxpayers are allowed to have two qualified homes. The first is your principal residence, which is always the place where you live for most of the tax year. The second can be any additional home you own, such as a vacation home, provided you use it for personal purposes. However, if you own more than two homes, you can choose which one to treat as your second qualified home. Regardless of which home you choose, it can never be an investment property; only personal-use property is eligible. In addition, the lender who extends a line of credit to you must take a security interest in a qualified home. Essentially, this provides the lender with an automatic ownership interest in the home in case of default on repayment.
2. Calculate outstanding loan balance. Since the maximum loan balance that you can deduct the interest on is $100,000, you must determine what your outstanding loan balance is for purposes of assessing what your home equity debt limit is.
3. Calculate your equity in the home. Your equity in the home is equal to its fair market value minus all outstanding mortgage balances. However, you don't include the home equity loan balance as a mortgage when calculating equity. The fair market value of your home is equal to the price you could obtain for it if you put the home up for sale.
4. Choose lower of equity or debt limit. You can never deduct the interest that accrues on more than $100,000 of the home equity loan's principal balance. Also, some of the interest is nondeductible if the loan balance exceeds the equity you have in the home. For example, if your equity is $75,000 and the outstanding loan balance is equal to $120,000, only the interest that accrues on $75,000 is deductible. In contrast, if both your equity and the loan balance are equal to $120,000, the maximum deduction you can claim is for interest that accrues on $100,000 of the loan.
5. Determine annual interest payments. Regardless of your loan balance and equity, you can never deduct more interest than you actually pay. Your lender will send you a Form 1098 to report all interest payments it receives from you during the year, which is the amount you must use when reporting the deduction on Schedule A of your tax return. However, you may need to reduce the deduction if your debt limit is less than your home equity loan balance. For example, if you are limited to the interest that accrues on $75,000 of your $100,000 home equity loan, your deduction should equal 75% of the interest payments reported to you on the 1098.
Items you will need
- IRS Form 1098
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