Can You Claim a Tax Deduction for Interest on a Home Equity Loan?

Generally, you can claim an itemized deduction on your federal income tax return for the interest you pay on a mortgage secured by your main home or second home. You can deduct the interest on mortgages of up to $1 million ($500,000 if you are married filing separately) to buy, build or improve your home. You can deduct the interest on a home equity loan of up to $100,000 ($50,000 if married filing separately) if you use the proceeds for something other than buying, building or improving your home.

But there is a limit for home equity loans. The interest you can deduct, without having to justify how you used the proceeds, is limited to the difference between the fair market value of your home and the outstanding balance of your mortgage.

For example, if your home has a fair market value of $200,000 and the outstanding balance on your mortgage is $180,000, you could deduct interest on up to $20,000 of home equity loans. If the fair market value of your home is less than the outstanding balance on your mortgage, you could not deduct any interest on a home equity loan that was not used to buy or build a second home, or improve your main or second home.

But, if you take out a home equity loan to make improvements on your main home or to buy, build or improve a second home, the interest on the home equity loan would be deductible up to the limit. The limit would be $1,000,000 (or $500,000) less the outstanding balances on any combined mortgages on your main home and second home.

If you use part of the proceeds from a home equity loan to buy, build or improve your main or second home and part for other purposes, you could deduct a portion of the interest as home mortgage interest. The deductibility of the interest on the rest of the home equity loan depends on how you used the proceeds.

If you use the proceeds from a home equity loan to purchase a rental property, the interest would be deductible on Schedule E as an expense to produce rental income. If you use the proceeds to purchase investments, such as stocks, you may be able to claim the interest as an itemized deduction on Schedule A for investment-related expenses. If you use the proceeds in your business, the interest on the loan would be deductible as a business expense on Schedule C. If used the proceeds on your farm, you could deduct the interest on Schedule F. And if you used a home equity loan to pay for qualifying education expenses, you could claim a deduction for student loan interest.

Sources:
George Sanz, "Home-equity interest deduction", Bankrate.com
How do I: Claim a tax deduction for home equity interest, Bankrate.com
Publication 936, Home Mortgage Interest Deduction, IRS