Anytime a lump of money lands in your lap, it's natural to have tax questions, and it's no different with home equity loans. These loans let you borrow money against the portion of your home's value that you "own" — that is, the difference between what the home is worth and what you still owe on the mortgage.
Is This Money Taxable?
Here's the thing about income tax: You only have to pay it on income. The money you get from a lender doesn't count as income because you'll ultimately be paying it back. Borrow $20,000 against your home's equity, and over time you'll repay the whole $20,000, plus interest. Since you don't come out "ahead" in the final analysis, you don't have any income, and thus no tax liability.
What Can I Deduct?
If you itemize your tax deductions, you'll usually be able to deduct the interest you pay on a home equity loan. (You can't deduct the principal, though.) The Internal Revenue Service says money borrowed against your home falls into one of two categories: "acquisition debt" and "home equity debt." Acquisition debt is money you used to buy, build or improve your home. Home equity debt is everything else you owe on your home. So if you use a home equity loan to improve your home, it actually counts as acquisition debt. But if you use it for something else — car, school, vacation, wedding, doggy day care — it's home equity debt. You can deduct interest on up to $100,000 worth of home equity debt.
When Can't I Deduct Interest?
If you don't itemize your deductions — that is, if you take the standard deduction on your tax return — you're out of luck. You can't deduct your home equity interest. Also, if you are subject to the alternative minimum tax (AMT), you can't deduct interest on home equity debt. The AMT is designed to keep high earners from avoiding tax entirely through big deductions. You'll find out when doing your taxes whether the AMT applies to you. If it does, you'll be unable to deduct interest on any loans against your home that you didn't actually use to buy, build or improve the home. (Unfortunately, the IRS doesn't consider putting a new car in the garage to be "improving" the home.)
Any Other Benefit?
So long as you're not subject to the AMT, you can use your home equity loan on anything you want and still deduct the interest. Interest on other loans isn't deductible at all. So if you want, say, a new car, you may be better off taking out a home equity loan and using that money to pay cash for the car — then deducting the interest — than actually taking out a car loan. And since interest rates on home equity loans are almost always lower than on credit cards, it's not uncommon for people to use home equity loans to consolidate high-interest debt, with the added benefit of writing off the interest on their taxes.
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