If the number on line item number 37 of your federal 1040 tax return “Amount You Owe” gives you heart palpitations, dont despair. The Internal Revenue Service (IRS) may be willing to work with you as long as you stay in contact and take the necessary steps to get your tax bill paid.
What are the steps you can take to pay the IRS if you dont have cash readily available? The best answer for taxpayers in this situation who own homes may come as a surprise: They should consider a home equity loan or line of credit (HELOC) to pay taxes due..
Even if you dont know exactly how youll pay off your tax debt, you should still be sure to file on time. Not filing on time can be costly. For example, the penalty for failure to five is 5% of the taxes due each month, capping out at 25% of the amount you owe, while the penalty for failing to pay the taxes you owe on time is 0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid. This penalty won’t exceed 25% of your unpaid taxes.
While the bad news is that these can and will both be charged at the same time , the somewhat better news is that when they are charged together, the failure to file penalty is reduced by the amount of the failure to pay penalty. For example, instead of a 5% failure to file penalty for the month, the IRS would change you a 4.5% failure to file penalty and a 0.5% failure to pay penalty.
The lower you wait, the worse it gets, since interest also accrues on the unpaid balance and compounds daily from the due date of the return. As of this writing, the annual interest rate you would be charged is 7%, but it varies each quarter.
Still, theres probably no reason for you to have to pay any additional fees or penalties, since at least four options are available to you for paying outstanding tax obligations, each has advantages and drawbacks.
Paying taxes can be a real pain especially when you end up with a unexpectedly high tax bill. As April 15th approaches many people start to stress about how they are going to come up with the cash to pay what they owe to Uncle Sam. If you find yourself in this situation, one option to consider is taking out a home equity loan to get the funds needed to pay your tax bill.
I know that might sound a little crazy at first – taking out debt to pay off debt? But hear me out, as a home equity loan can actually be a smart financing option in some cases when you need to cover a tax liability. In this article, we’ll walk through when it makes sense to use home equity to pay taxes, the pros and cons, interest deductibility, and alternatives.
When Does It Make Sense To Use Home Equity for Taxes?
First off let’s discuss the situations when tapping into your home’s equity to pay taxes is advisable
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You have a high tax bill you can’t cover with current cash flow If you get hit with a unexpectedly high tax liability and don’t have enough cash on hand to cover it, a home equity loan can provide a way to bridge the gap. This avoids pricy IRS penalties and interest.
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You want to maximize retirement savings. If contributing to retirement accounts would make paying your tax bill difficult, home equity could allow you to maintain your retirement savings level while covering what you owe the IRS.
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You need a better interest rate. Credit cards often have double digit interest rates. Meanwhile, home equity loans and lines of credit often offer single digit rates, meaning lower interest costs.
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You need flexible repayment terms. Banks will often structure home equity installment loans with flexible terms from 5 to 30 years. This keeps monthly payments manageable.
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You have substantial available equity. Homeowners with a significant amount of equity built up in their property tend to get approved for larger loan amounts and better rates.
As you can see, home equity financing starts to make a lot of sense if you have a high tax bill due and limited current income and savings. It provides a way to tap into one of your largest assets to cover major financial obligations.
Potential Drawbacks of Home Equity Loans for Taxes
However, there are also some potential disadvantages to think through before deciding if a home equity loan is right for your situation:
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Closing costs – Home equity loans often come with closing costs ranging from 2% to 5% of the loan amount. Factor these fees into your total costs.
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Repayment obligation – While the flexible terms help, you are taking on required monthly principal and interest repayment obligations when borrowing against your home.
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Risk of foreclosure – If you default on a home equity loan, the lender can potentially foreclose on your home. Make sure you can afford the monthly payments.
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Refinancing difficulty – Outstanding home equity debt can make it harder and more expensive to refinance your primary mortgage in the future.
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Interest may not be deductible – Recent tax law changes mean the interest is only deductible in limited circumstances.
While home equity loans make sense in many tax payment scenarios, they aren’t for everyone. Think through the risks and whether this type of loan aligns with your broader financial situation and goals.
Is Home Equity Loan Interest Tax Deductible?
Historically one of the major appeals of home equity loans was the ability to deduct the interest on your taxes. However, this changed with the Tax Cuts and Jobs Act starting in 2018. Now, there are limits on home equity loan interest deductibility:
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Total mortgage cap – You can only deduct interest on up to $750,000 total of mortgage and home equity debt.
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Use of funds – Interest is only deductible if the loan is used to “buy, build or substantially improve” the home securing the loan.
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Itemizing required – You can only claim mortgage interest deductions if you itemize (instead of claiming the standard deduction).
As you can see, the rules have gotten tighter, but deductibility is still possible if your loan satisfies the right criteria. Just don’t count on full deductibility like in the past. Consult a tax professional to understand your potential deductibility before moving forward.
Tax Payment Alternatives To Compare
While a home equity loan or line of credit can be a great option to cover a tax bill, also consider these other possibilities to compare costs and risks:
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Credit cards – This is an easy financing option but comes with variable, usually high, interest rates.
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401(k) or IRA withdrawals – You can tap retirement funds early but will face taxes and potential penalties.
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Personal loans – These are easy to qualify for but also feature higher rates.
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Payment plan – The IRS lets you pay over 6 years. There’s a setup fee and interest charges.
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Mortgage refinance – Cash-out refinancing converts home equity to cash in a new loan.
Look at the pros and cons of each option and run the numbers to see which works best for your tax payment needs. Don’t automatically assume home equity is the cheapest route.
Final Thoughts on Using Home Equity to Pay Taxes
Post-tax season shock is never fun, especially when you end up owing more than expected to the IRS. If you don’t have enough current cash flow to cover what you owe, a home equity loan can provide critical financing to avoid penalties and minimize interest costs.
Just be sure to run the numbers accounting for all fees and deductibility restrictions. And carefully consider whether taking on another monthly obligation secured by your home aligns with your overall finances. Used judiciously, tapping home equity for taxes can be a smart financial move. But go into the decision with eyes wide open to the risks and alternatives.
What are your thoughts on using home equity to pay taxes? I’d love to hear from you in the comments below!
Use a home equity loan to pay taxes
You may be surprised if you are wondering, “Can you use a home equity loan to pay taxes?” Getting a loan to pay off the IRS may sound unappealing, but the IRS advises that one of the best solutions for paying off tax debt is a home equity loan. They state this in IRS Topic 202: “You should consider financing the full payment of your tax liability through loans, such as a home equity loan from a financial institution. The interest rate and any applicable fees charged by a bank or credit card company may be lower than the combination of interest and penalties set by the Internal Revenue Code.”
Since the Tax Cuts and Jobs Act back in 2017, you can no longer deduct the interest on home equity debt unless the funds are used to “buy, build or substantially improve” a qualified residence. Since paying your tax bill isnt one of those, youll only be able to enjoy easy access to relatively low-cost funds, as theres no longer any additional tax benefit for using your home equity to pay your tax bill or nearly anything else.
Fees for setting up a home equity line of credit can be minimal, usually only including costs for a credit check and an appraisal of your home. If you have good credit and some equity in your home, you may be able to get a home equity line of credit (HELOC) at an affordable interest rate. Typical home equity pricing starts at about the Prime Rate plus two percentage points, but can be higher or lower depending on your credit, debt-to-income ratio, how much equity you are borrowing and other factors. Some lenders will allow you to establish a line of credit, then convert funds youve drawn into a fixed-rate, fixed repayment term option if you prefer one.
Terms for home equity loans and lines of credit can last as long as 20 years. HELOCs may also only require payments of interest for up to the first 10 years of the line, which may afford you some financial flexibility for a time.
Getting a home equity loan may result in lower payments than the IRS can offer in an installment plan. Review our comprehensive guide to home equity loans and lines of credit to fully understand how they work.
IRS installment payment plan
The IRS offers payment plans. You can request an installment payment plan for your tax debt by proposing a monthly payment amount to the IRS. In a perfect world, youll be able to agree to a monthly amount thats acceptable to the IRS, as well as one within your budget.
As with most other repayment options, there are downsides to an IRS installment plan. For example, theres a setup fee charged for installment agreements. IRS installment plan fees vary and depend on how you set up the account and how you intend to make payments, and range from $43 to $225.
About Home Equity Loans & Taxes
FAQ
Can I get a home equity loan to pay taxes?
Can you get a loan to pay back taxes?
Can you write off home equity loan on taxes?
Do you have to pay taxes on home equity cash out?
Can I use a home equity loan for tax purposes?
You can use a home equity loan for many different reasons, including the following common ones: Under the Tax Cuts and Jobs Act, the IRS allows homeowners to deduct interest paid on a home equity loan or home equity line of credit only if they used the funds for the house.
Can a home equity loan be tax deductible?
Even if you took out the loan before the new tax bill passed, you can no longer deduct any amount of interest on home equity debt. This new tax rule applies to all home equity debts, as well as cash-out refinancing. That’s where you replace your main mortgage with a whole new one, but take out some of the money as cash.
How do I deduct home equity loan interest on my tax return?
Gather your documents To deduct home equity loan interest on your tax return, gather the following documents: Mortgage interest statement (Form 1098): This form is provided by your home equity loan lender and shows the total amount of interest paid during the previous tax year.
Can I get a home equity loan without a tax return?
Most home equity lenders require a copy of your most recent two years of federal income tax returns. They use your tax return to help verify your income and ensure you can afford to repay the loan. However, it may be possible to get a home equity loan or HELOC without a tax return, depending on the lender’s requirements and your situation.