Home Equity Line of Credit (HELOC) is availed for meeting expenses that are of a recurring nature. This is because HELOC is a type of revolving credit that allows the consumer to make withdrawals, up to the sanctioned limit, by using a check. The consumer is usually expected to pay interest on the HELOC that is variable and fluctuates with the prime rate of interest. The following write-up deals with home equity line of credit and tax deduction for the amount of interest paid on HELOC.
A HELOC can be a second mortgage loan or a first mortgage. If a borrower uses a HELOC to refinance the primary mortgage, the home equity line of credit becomes a first mortgage. Regardless of whether the HELOC is a second mortgage or a first mortgage, the total amount sanctioned in lieu of the line of credit depends on the borrower’s equity in the house, which is computed as the difference between the market value of the house and the remaining primary mortgage balance. Interest that is paid on a primary mortgage, a second mortgage, a home equity loan is known as home mortgage interest.
According to the Internal Revenue Service (IRS), home mortgage interest is tax deductible if:
- the mortgage has been legally availed on a qualified home in which the borrower has an ownership interest
- the borrower can file Form 1040 and itemize deductions on Schedule A (Assuming that the lender and the borrower share a true debtor-creditor relationship)
The amount of deduction for home mortgage interest depends on when the mortgage was availed, the total amount borrowed and the way the mortgage proceeds are used. From the point of view of tax treatment, mortgages may be classified as grandfathered debt, home acquisition debt or home equity debt.
Mortgages that were procured on or before October 13, 1987 are known as grandfathered debt, while those availed after October 13, 1987 may be classified as home acquisition debt or home equity debt. The difference between home acquisition debt and home equity debt is that the former is used for buying, building or improving the qualified home, while the latter is used for other purposes. It can be used to make improvements on a home or the line of credit may be availed for debt consolidation or for paying-off car loans, medical expenses, college expenses, etc. It may also be used to refinance or replace the existing primary mortgage. Thus, depending on the situation, a home equity line of credit (for tax deduction) may qualify as a home acquisition debt.
According to the IRS, if all the mortgages that have been availed fit into one or more of the aforementioned categories, viz. grandfathered debt, home equity debt or home acquisition debt, at all times of the year, one can deduct the entire amount of interest on the mortgages. This is the simplest case. If one or more mortgages do not fit into any of these categories or if a mortgage fits into more than one category, the situation becomes tricky.
Obviously, there is an upper limit to the amount that can be declared as home equity debt. According to IRS, the total home equity debt on your main and second home is limited to the lesser of the following two conditions:
- $100,000 ($50,000 if married filing separately)
- The total of each home’s fair market value (FMV) minus the amount of its home acquisition debt and grandfathered debt (aggregate of the two should not be below zero). For each home, all the three values are determined on the date that the last debt was secured by the home.
Given the complexity of tax treatment for home mortgage interest, specifically home equity line of credit and tax deductions for interest, one cannot over-stress the prudence of consulting a tax adviser for filing tax returns.