Selling your home or investment property can leave you responsible for a sizable capital gains tax bill. As a result, many people consider taking on home equity debt, such as a HELOC, to reduce their taxable earnings. While this can sometimes be an effective way to avoid capital gains tax, it isn’t always.
We’ll walk through what’s legally possible with reducing capital gains through home equity debt, some common misunderstandings, and how tapping home equity can be part of broader tax planning.
Keep in mind that this is educational content and should not be construed as tax advice. Be sure to consult a financial planner or tax professional to understand how utilizing home equity debt could personally impact you.
- Home equity debt does not directly reduce capital gains taxes, since borrowed funds are not considered taxable income.
- You may lower your tax burden only if you use that debt for major home improvements that increase your property’s cost basis.
- Because of added debt, interest rate risk, and limited return on improvements, this strategy should be part of a broader financial plan, not a primary tax solution.
Understanding Capital Gains Taxes on Real Estate
Capital gains tax is the tax obligation incurred from selling assets, such as stocks or real estate. Capital gains are treated differently from ordinary income, which includes the wages or salary you earn from working.
Capital gains are split into two categories for tax purposes: short-term and long-term.
- Short-Term Capital Gains: Proceeds from assets held for one year or less. Short-term gains are typically taxed at the same rate as ordinary income.
- Long-Term Capital Gains: Proceeds from assets held for more than one year. Long-term gains are typically taxed at lower rates than ordinary income, with most filers paying 0%, 15%, or 20%, depending on their filing status and income level.
How to Calculate Capital Gains on Real Estate
Capital gains are calculated by subtracting the cost basis of your home from the price you sell it for. Your cost basis is the amount you paid for the property, including some closing expenses and legal fees, plus the cost of major improvements (such as adding a new roof or remodeling a kitchen), minus any losses you incurred (such as damage from a fire or flooding).
For Example: You purchased your home, with or without mortgage financing, for $300,000, and you paid an additional $10,000 in applicable closing costs. You later upgraded the roof for $30,000. In this scenario, your cost basis would be $340,000. If you were to sell the home for $450,000, your capital gains would be $110,000.
While the IRS does allow homeowners to exclude primary residence capital gains of up to $250,000 ($500,000 if married and filing jointly) in some scenarios, large gains, particularly in rapidly rising markets, can often catch sellers off guard and add a considerable amount to their tax bill.
What Is Home Equity Debt and How Homeowners Use It
Home equity debt results from borrowing against the equity you’ve established in your home, which is typically accomplished through a:
- Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit, tied to your home equity, that you can use numerous times over a multi-year period.
- Home Equity Loan: Home equity loans allow you to receive a portion of your equity as an upfront lump sum of cash and have stable and predictable monthly payments.
- Cash-Out Refinance: Doing a cash-out refinance rolls your existing mortgage into a new, larger loan with a brand-new interest rate, monthly payment, and repayment schedule.
Building Home Equity
You build equity in your home through two primary methods: market appreciation and paying down your mortgage.
Say, for example, you purchase a $325,000 home and take out a $300,000 mortgage. Here, your down payment essentially converts into $25,000 of equity. After several years of ownership, your property has risen in value to $400,000, and you’ve paid down your loan balance to $250,000. This equates to $150,000 in built-up equity.
According to the Federal Reserve, American homeowners possess a cumulative $34.4 trillion in established home equity.
Utilizing Home Equity Debt
When you take on home equity debt, you simply borrow against the equity in your home. Unlike selling and converting your equity into capital gains, tapping into home equity provides you with borrowed money, not income.
As such, homeowners sometimes use HELOCs and other forms of home equity debt as a financial planning tool. Refi.com offers a variety of resources that explore the options for accessing home equity and the trade-offs that come with them.
Can Home Equity Debt Reduce Capital Gains Taxes?
While home equity debt can be used as part of a broader financial planning strategy, it does not inherently increase your cost basis or reduce the capital gains taxes owed.
It’s a common misconception that tapping into home equity increases your tax burden, since it increases the amount you owe on your home. In reality, this is not the case.
However, one exception to this rule exists: using your borrowed equity to make major repairs or improvements to the home increases your cost basis and can reduce your capital gains taxes.
For the most part, though, if you’re considering borrowing against your home’s equity for strategic purposes, you should view it as a cash-flow and timing tool, not a tax deduction.
Risks of Using Home Equity for Tax-Related Strategies
Taking on home equity debt, whether through a HELOC or another type of loan, can be a powerful financial planning tool. It can even reduce your tax burden, so long as you use the funds to make major improvements to your property. However, you must consider some risks before using home equity as part of a tax-related strategy.
1. Home Improvements Typically Add Less Value Than They Cost
While using your equity to improve your home will raise your cost basis, you’re unlikely to fully recoup the amount spent. As such, this strategy doesn’t always make sense unless you plan to continue living in the home and benefit from the improvements or unless you use them to increase rental income.
2. Adding Debt Will Increase Your Monthly Mortgage Payments
Borrowing against your home equity means taking on additional debt. This requires you to make payments on the new loan, which, in most cases, will increase your overall housing expenses. Be sure your finances are stable enough to comfortably afford the additional mortgage payment.
3. Variable Interest Rates Can Cause Costs to Fluctuate
Home equity debt options with variable interest rates, such as HELOCs and some cash-out refinances, can have monthly payments that fluctuate with broader financial market movements. If overall interest rates rise, you can expect your monthly payments to increase as well. If the rate change is drastic, you could end up paying far more than you initially planned.
4. Issues Stemming From Reducing Your Equity Stake if Property Values Decline
Tapping into your equity reduces your ownership stake in the home. Some HELOC lenders, for example, may let you borrow as much as 90% (or sometimes even more) of your home’s value. If property prices decline in your area, reducing your equity stake too much could make it difficult to refinance or sell without coming out of pocket with extra funds. Owing more than your property is worth is often called being underwater on your mortgage.
5. Tax Related Concerns
In addition, there are also some tax-related risks to keep in mind, such as misinterpreting often-complex IRS guidelines and assuming you’ll qualify for deductions related to your equity debt usage that don’t actually apply.
As with all tax-related issues, it’s wise to take a conservative approach to planning and consult an experienced professional to fully understand how your tax obligations will be affected.
FAQs
Still unsure whether you should use a HELOC or other type of home equity debt as a method for reducing your capital gains taxes? Here are straightforward answers to some of the most frequently asked questions on the topic.
What Is Capital Gains Tax on Real Estate?
Capital gains tax on real estate is the tax obligation you incur by selling your property for more than your cost basis, which is typically the price you paid for it plus any significant improvements you made. Long-term capital gains tax rates vary by income and filing status, but most homeowners pay 0%, 15%, or 20%.
Can Home Equity Debt Reduce Capital Gains Taxes?
Home equity debt does not inherently reduce capital gains taxes since you’re effectively receiving borrowed funds that you can use for any purpose you choose. However, using a HELOC, or the lump sum proceeds from other debt options, to make major repairs or improvements to your home can increase your cost basis and reduce your capital gains liability.
Can Refinancing Help Offset Capital Gains Tax?
Refinancing does not offset capital gains tax on its own because, as with a home equity line of credit, you can use the cashed-out equity in whatever manner you see fit. Any portion of the funds from your refinance used for home improvements, however, can help to offset your tax obligation when you sell.
Taking the Next Steps
Using a HELOC, or another lending product, to access your home equity can be a practical tool for financial planning, but taking on home equity debt doesn’t erase capital gains taxes on its own.
You can increase your cost basis and reduce your capital gains by utilizing the equity to make significant improvements and repairs. Still, you’re unlikely to increase the property’s value by the full amount you invest in doing so. As such, this may not be a practical solution for homeowners planning to sell in the near future.
If you do choose to use your home equity to reduce your capital gains tax obligation, make sure to consult a qualified tax professional, explore your equity-accessing options responsibly, and check out the resources available on Refi.com to compare different scenarios and understand the long-term impacts and costs.
