THE TAX IMPLICATIONS OF USING HOME EQUITY
THE BASICS OF HOME EQUITY FINANCING
First, let's review the basics of home equity financing. Home equity financing allows you to borrow against the equity you've built up in your home. Equity is the difference between your home's current value and the amount you owe on your mortgage.
There are two types of home equity financing: a home equity loan and a home equity line of credit (HELOC). A?home equity loan?provides a lump sum of money that you repay over a fixed period. A?HELOC, on the other hand, is a line of credit that you can draw from as needed and repay over time.
Both types of home equity financing have potential tax implications, which we'll explore next.
POTENTIAL DEDUCTIONS FOR HOME EQUITY LOANS AND HELOCS
One potential benefit of home equity financing is the ability to deduct the interest paid on the loan or HELOC. However, the rules around these deductions have changed in recent years.
Before 2018, you could deduct the interest paid on a home equity loan or HELOC up to $100,000, regardless of how you used the funds. This made home equity financing an attractive option for many homeowners looking to consolidate debt, pay for home improvements, or cover other expenses.
However,?the Tax Cuts and Jobs Act of 2017?changed the rules. As of 2018, you can only deduct the interest paid on a home equity loan or HELOC if you use the funds to?"buy, build, or substantially improve"?your home. If you use the funds for other purposes, such as paying off credit card debt or financing a vacation, the interest is no longer deductible.
It's important to note that the new rules only apply to loans and HELOCs taken out after December 15, 2017. If you took out a home equity loan or HELOC before that date, you may still be able to deduct the interest paid, regardless of how you used the funds.
TAX IMPLICATIONS OF SELLING A HOME AFTER USING HOME EQUITY
Another potential tax implication of using home equity financing is what happens when you sell your home. If you sell your home after using home equity financing, the amount you borrowed will need to be repaid from the proceeds of the sale.
However, the tax implications of selling a home after using home equity financing depend on several factors, including how long you've owned the home and how much you've borrowed.
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If you've owned your home for more than two years and have lived in it as your primary residence for at least two of the past five years, you may be eligible for the home sale exclusion. This exclusion allows you to exclude up to $250,000 in capital gains if you're single or up to $500,000 if you're married filing jointly.
However, if you've used home equity financing, the amount you borrowed will need to be repaid from the proceeds of the sale before calculating any capital gains. This means that the amount you can exclude from capital gains may be reduced or eliminated altogether.
It's also worth noting that if you sell your home at a loss, you may be able to deduct the amount of the loss on your taxes. However, if you've used home equity financing, the amount you borrowed may reduce the amount of the loss you can deduct.
OTHER CONSIDERATIONS
There are a few other tax implications to keep in mind when using home equity financing. For example, if you use the funds to make home improvements, you may be able to increase your home's basis, which can reduce your capital gains when you sell.
Additionally, if you use home equity financing to buy a rental property, the interest you pay may be deductible as a business expense.
It's also important to keep accurate records of your home equity financing transactions and interest payments, as this information will be needed when you file your taxes.
THE BOTTOM LINE
In summary, home equity financing can provide a source of funds for various expenses, but it's important to understand the tax implications. The interest paid on a home equity loan or HELOC may be deductible if you use the funds to "buy, build, or substantially improve" your home. If you sell your home after using home equity financing, the amount you borrowed will need to be repaid from the proceeds of the sale, which can affect your capital gains.
As with any financial decision, it's important to consult with a tax professional to understand how home equity financing may affect your individual tax situation. By doing so, you can make informed decisions about whether home equity financing is the right choice for you.