The HELOC Interest Deduction: What to Know Before Filing Taxes

As tax season swings into full gear, you may be preparing your own taxes and wondering what you can and cannot deduct. One such deduction seems so simple at the concept level, yet the IRS nevertheless succeeded in overcomplicating matters.

The deduction I’m speaking of is the Home Equity Line of Credit (HELOC) interest deduction.

A HELOC is simple a loan in which the lender agrees to lend some amount over some time period and collateralize that loan against the borrower’s equity in the home. Though I’m not going to get into the advantages and disadvantages of a HELOC, borrowers find them advantageous, as they tend to be easier to obtain and less costly than traditional loans or a full blow cash-out refinance.

So you have a HELOC, and the two big questions of the day are:

Is the interest deductible?
If yes, where do I report the interest expense on my tax returns?

Qualified Home Test

We need to determine whether the property in which we are taking a HELOC against will be considered a “qualified home” for IRS purposes. If the home is not a qualified home, then the interest expense from the HELOC will not be deductible.

A qualified home is your main (primary residence) or second (vacation) home. You can only have one main home at a time. If you rent your second home for part of the year, you must use it as some point to officially qualify it as a second home. Specifically, you must use the home for more than 14 days or 10 percent of the number of days the home was rented at a fair rental price.

If you are house hacking, only the portion of the residence that you specifically live in will be considered the qualifying portion. Which leads me to my next point…

A rental property is not a qualified home. This means that if you take a HELOC against a full-blown rental, you’re out of luck on deducting the interest. Unless, of course, you are considered to be “in the business of rentals.” If this applies to you (it applies to most investors), then the interest may be deductible depending on what you use the HELOC funds for.

Debt Categories

Once we determine that the home is a qualified home, we need to understand the various types of debt and interest and the associated deductible limits.

There are two main categories of debt in regards to real estate: acquisition debt and home equity debt.

Acquisition Debt

Acquisition debt is a mortgage you took that is secured by your qualified home to buy, build, or substantially improve said qualified home.

Home Equity Debt

Home equity debt is debt other than acquisition debt that is secured by your qualified home but does not exceed the difference between the fair market value (FMV) of the home and the acquisition debt utilized to secure the home.

For example, if you have a qualified home valued at $100k and your mortgage on that home is $90k, you can get a HELOC for as large as you’d like, but you’d likely only be able to deduct the interest attributed to the $10k difference. You cannot deduct interest on the HELOC that causes the total debt to exceed the FMV of the home.

Unless, of course, you use your HELOC loan funds for business or investment purposes.

Deductibility of Interest and Interest Categories

Applying your loan funds to investment or business activities will allow you to deduct the interest in other areas of your tax return rather than having to itemize and be subject to limitations.

Continuing the above example, let’s assume you had taken out a $40k HELOC in addition to the $90k acquisition debt that is already on the property. The interest attributed to the first $10k can be deducted on Schedule A – Itemized Deductions. The remaining $30k may be deductible if you use the loan proceeds to buy a rental property or pay for business equipment and expenses.

When you use the proceeds for business or investment purposes, you’ve effectively reclassified the loan and the associated interest from a qualified home loan to an investment or business loan. Luckily, we get to trace the transaction to determine where the proceeds were used and deduct the interest accordingly.

On the other hand, you can completely avoid the above example of “splitting” the interest deduction between Schedule A and deducting in your business or investments if you allocate 100 percent of the HELOC proceeds to your business or investments. Just remember that wherever the loan funds are used, that’s where the interest is deducted.

If you use the HELOC for any other purchase, such as a car, the interest is considered qualified home interest and is deductible on Schedule A – Itemized Deductions. However, it’s important to note that there are limitations to how big of a HELOC you can take and still be allowed to deduct the interest (discussed below).

Additionally, if you are subject to the Alternative Minimum Tax (AMT), you will fall under a completely new set of rules and may only be allowed to deduct HELOC interest if you used the funds to improve your home or for business or investment purposes.

The $100k Home Equity Debt Limit

Let’s assume you are approved for a HELOC of $200k. Should you draw the full amount?

Yes and no. Yes if you can apply the funds for business or investment purposes; no if you can’t.

The reason? The deduction for qualified home interest is limited to the interest on $1M of acquisition debt and $100k of home equity debt. We discussed both types of debts above, but just remember a $100k threshold for your HELOC for simplicity’s sake.

Keep in mind, this threshold applies only to deducting qualified home interest. It does not apply to business or investment interest, hence the reasoning to use the HELOC for your business or investments if feasible to do so.

Summary

That was probably a lot of seemingly mixed up rules. So let’s run down it again at a high level.

For the interest to be deductible on a HELOC, the loan must be against a qualifying home, which is your main or second home.

There are two types of debt: (1) acquisition debt and (2) home equity debt. Home equity debt is not acquisition debt.

There are several types of interest, the main ones being qualified home, business, and investment interest.

If you do not use the HELOC for business or investment purposes, the deductibility of interest is subject to limitations. Those limitations are: (1) interest will on be deducted on the HELOC portion that does not exceed the FMV of the qualifying home minus the home’s acquisition debt, and (2) the interest on a HELOC is only deductible on the first $100k of HELOC funds, unless used for business or investment activities.

And last but not least, if you are subject to the AMT, you’ll be happy (sarcasm!) to know you get a whole new set of rules that are beyond the scope of this article.

Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.

Investors: Have any questions about this deduction?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.