Homeowners who tap their property’s equity for cash face a tax rule that trips up filers every spring: the IRS allows a deduction for interest on a home-equity loan or line of credit only when the borrowed funds pay for buying, building, or substantially improving the residence that secures the debt. That restriction, rooted in the 2017 Tax Cuts and Jobs Act, replaced a more permissive regime that had let borrowers write off the interest no matter how they spent the money. With 2025 returns now being prepared, the distinction between a kitchen renovation and a credit-card payoff can mean hundreds or thousands of dollars in lost deductions.
Why the TCJA Use-of-Proceeds Rule Still Catches Borrowers Off Guard
Before 2018, homeowners could deduct interest on up to $100,000 of home-equity debt used for virtually any purpose, from tuition bills to vacation spending. The TCJA suspended that broad write-off for tax years beginning after December 31, 2017, according to the Joint Committee explanation of Public Law 115-97. Under the current framework, home-equity loan or HELOC interest qualifies as deductible only if the proceeds fall into one of three categories: acquiring, constructing, or substantially improving the taxpayer’s qualified residence.
The gap between what lenders report and what the IRS actually permits creates confusion. Mortgage servicers still mail Form 1098 statements each January showing the total interest paid in Box 1. Yet not every dollar on that form is automatically deductible. IRS training materials used in the Volunteer Income Tax Assistance program walk through a scenario in which a taxpayer who used home-equity proceeds for purposes other than home improvement simply cannot claim the deduction, regardless of what the 1098 shows.
Because the standard deduction nearly doubled under the same 2017 law, fewer households itemize at all. Those who do itemize, however, must trace how they spent each draw from a HELOC or lump-sum home-equity loan. A homeowner who splits a $50,000 line of credit between a new roof and college tuition can deduct interest only on the portion tied to the roof. No public IRS dataset currently breaks out how many filers misallocate these claims, but the agency’s own guidance leaves little room for ambiguity about the rule itself.
How the IRS Defines “Substantially Improve” and Where Filers Report It
The statutory backbone sits in the acquisition-indebtedness rules in Section 163 of the Internal Revenue Code, which treats debt as qualifying only if it is incurred to acquire, construct, or substantially improve a qualified residence and is secured by that residence. The IRS restates the same standard across multiple public-facing documents, including homeowner guidance in mortgage-interest FAQs and the instructions for Schedule A on Form 1040.
Filers who qualify claim the deduction on Schedule A, Line 8a or 8c, depending on whether the interest appears on a 1098 or is paid to an individual seller. The practical test is straightforward: did the home-equity borrowing pay for work that adds value to the home, prolongs its useful life, or adapts it to new uses, such as an addition, major systems upgrade, or structural repair? Routine maintenance-like repainting a room or patching a small leak-typically does not rise to the level of a substantial improvement.
The IRS emphasizes that the residence securing the loan must be the same property that benefits from the improvement. Using a HELOC on a primary home to remodel a vacation cabin does not convert the interest into deductible acquisition debt for the primary residence. Similarly, using equity from a rental property to upgrade a personal home does not make the interest deductible as home-mortgage interest, though different rules may apply on a rental schedule.
Tracing Mixed-Use Borrowing and Avoiding Common Errors
Many homeowners use a single home-equity line for multiple purposes over several years, which complicates the tracing requirement. The IRS expects taxpayers to allocate interest between qualifying and non-qualifying uses based on how much of each draw went to eligible home projects. If a $40,000 HELOC balance reflects $25,000 for a new kitchen and $15,000 for debt consolidation, only 62.5% of the interest would be deductible as home-mortgage interest, assuming the overall loan balance stays within the broader home-mortgage limits.
IRS guidance on real-estate taxes and interest underscores that taxpayers cannot recharacterize non-housing expenses after the fact. If records do not show how the funds were spent, examiners may treat the borrowing as non-deductible home-equity debt. Tax professionals therefore urge clients to keep invoices, contracts, and bank records tying each HELOC advance to a specific project on the property that secures the loan.
Another recurring mistake involves cash-out refinances. When a homeowner refinances and takes extra cash, the portion of the new loan used to pay off the old qualified mortgage generally retains its character, but any additional cash must still meet the “buy, build, or substantially improve” test to generate deductible interest. Using the extra funds for investments, cars, or personal expenses can turn part of the new mortgage into non-deductible debt, even though it is secured by the home and reported on Form 1098.
Planning Ahead for Future Returns
For homeowners who expect to itemize, the use-of-proceeds rule now shapes how they plan projects and borrowing. Grouping major improvements into a single, well-documented borrowing can make it easier to substantiate the deduction later. Conversely, using a HELOC as an all-purpose emergency fund risks blurring the line between deductible and non-deductible interest.
As long as the TCJA framework remains in place, taxpayers who rely on home equity for cash will need to think like record-keepers as well as renovators. Understanding how the IRS defines acquisition debt, and documenting each dollar that goes into a substantial improvement of the property, can prevent surprises when it is time to total up itemized deductions on Schedule A.
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David M. Keller is a finance writer based in Columbus, Ohio, covering personal finance and consumer-focused economic topics. He earned his degree in journalism from Ohio University and began his career reporting on local business and economic trends for a regional media outlet. Since then, he has contributed to a variety of online publications, focusing on clear, practical coverage of topics such as cost of living, debt, and everyday financial decision-making.
