It sounds almost too good to be true. Taking a tax deduction for your credit card interest or car loan interest. Normally, these type of deductions are limited to businesses. But if you are willing to put up your home as collateral, the IRS lets you deduct the interest -- with certain limits.
You can deduct the interest on a mortgage you use to buy your home. Home equity loans work the same way, but you can use the money for any purpose. You might use the money to make a major purchase such as a car, or you might use it to pay college expenses. The deduction is taken as an itemized deduction on Schedule A of your federal tax return.
As long as the debt is backed by your home, you can deduct the interest on up to $100,000 in loans, or up to $50,000 if you are married filing separately. The debt can be backed by either your first or second home. However, your limit might be lower than $100,000 if you don't have that much real equity in your home. Some banks may give you an equity line of credit that exceeds the amount allowed for the deduction allowed by the IRS.
The IRS allows you to claim the deduction only for the amount of equity you have based on the current fair market value of your home. For example, if your home is valued at $200,000, and your mortgage balance is $150,000, your total equity is $50,000 for purposes of claiming the deduction. It doesn't matter how much you originally paid for the home. If you take a home equity loan for $75,000, you can only claim a deduction for the interest on $50,000 of the loan.
While the tax benefits of home equity loans are appealing, the obvious danger is that you might lose your home if you can't keep up your payments. Normally you have some protection against creditors coming after your house if you default on a personal loan. But when you make the home your collateral, you are opening up new doors. The Federal Reserve Board recommends that consumers limit home equity loans to major purchases and expenses, and that they avoid using them for day-to-day expenses.
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