When you have a healthy amount of equity in your home, a home equity line of credit (HELOC) can be a valuable financing tool. You can use that money to pay off higher-interest debts (car loans, credit cards, student loans, etc.) or it can be applied toward an investment such as buying a rental property or making improvements on your home to increase its equity value even more.
Unfortunately, HELOC interest is treated a bit differently than traditional mortgage interest by the IRS. In fact, it was a specific part of the Tax Cuts and Jobs Act (TCJA) to declare HELOC interest as no longer tax deductible. If you know what you are doing and have a strong tax plan, however, you can actually still find certain tax benefits from your home equity line of credit.
The IRS states that “you can no longer deduct the interest form a loan secured by your home to the extent the loan proceeds weren’t used to buy, build, or substantially improve your home.” This means that if you are using the loan to finance home improvements, its interest is still tax deductible. If you use it for something else, then it is not.
But wait just a minute. The IRS also says “you can choose to treat any debt secured by your qualified home as not secured by the home.” This is where we find some good news because the HELOC interest may actually be tax deductible based on interest tracing rules.
Interest tracing rules can work to your advantage. They allow the interest to be classified based on how the loan proceeds are used. Depending on how you use that debt and how you trace it through itemizing your deductions, the interest could potentially be tax deductible. With this in mind, let’s look at the most common uses for HELOC funds and whether or not they might be tax deductible.
If you use your HELOC loan to pay for “personal” thinks like paying off credit card debts, financing a vacation or buying a car, then the interest will not be deductible.
If you use your home equity line of credit to purchase certain investments, the interest may or may not be tax deductible. We’re talking about investments like stocks, bonds, land and securities. If the debt is used to invest in tax-exempt investments, the HELOC interest will not be tax deductible. If you have investment income (investment income less investment expenses), then some interest may be deductible. You will need to itemize your deductions to show that you made more income from your investment than the HELOC funds you invested.
Passive Activity Interest
Most rental properties will be considered “passive activity income” by the IRS unless you materially participate a certain amount of time in managing the properties. If you use your HELOC to put money down toward a rental property purchase, the interest can be deducted from your passive income earnings. There are some other passive income and passive loss rules you should know, so check out a couple of our recent blog articles:
Trade or Business Interest
If you materially participate in a real estate investment (such as a fix and flip) or other business venture in which you have invested your HELOC funds, the interest will actually be fully deductible as a business expense.
Basically, the Tax Cuts and Jobs Act primarily eliminated the interest deductions for people using HELOCs to finance personal purchases and debt payoffs. If the money is still being used for business and investment purposes that earn a provable income (whether passive or active), you can still deduct at least some of the debt interest.
For help putting your tax plan together and understanding your HELOC financing and investment options, the team at Illumination Wealth is here to help. We’ll guide you through everything you need to know about home equity lines of credits, tax planning and investment portfolio management. Contact us today to schedule a no-obligation introductory financial consultation.