Yes — home equity loan interest is tax deductible for a rental property when you use the borrowed money to buy, build, or improve that rental. The IRS follows the cash, not the collateral. Even though the loan is secured by your primary residence, interest on the portion of the proceeds spent on the rental is a business expense you claim on Schedule E, not a personal itemized deduction on Schedule A. That reclassification also frees the interest from the $750,000 acquisition debt cap that limits personal mortgage deductions.
What Controls the Deduction: Use of Proceeds, Not Collateral
The tax code disallows personal interest but carves out exceptions for interest tied to a trade or business, investment activity, passive activities like rentals, and qualified residence interest.1Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest Which category your interest falls into depends on what you did with the borrowed dollars. A home equity loan spent on a rental down payment produces rental business interest. The same loan spent on a car or credit card payoff produces nondeductible personal interest.
This confuses people because Form 1098 shows the interest on a loan tied to your home address, which reads like a personal housing expense.2Internal Revenue Service. Form 1098 (Rev. April 2025) Mortgage Interest Statement The lien location is irrelevant to the deduction. If $80,000 of the proceeds went straight into a rental property purchase, the interest on that $80,000 is a rental expense regardless of which house secures the note.
Trace the Money So You Can Prove It
Treasury Regulation 1.163-8T requires you to allocate interest by tracing loan disbursements to specific expenditures. The interest then follows whatever category those expenditures fall into.3eCFR. 26 CFR 1.163-8T – Allocation of Interest Expense Among Expenditures In practice you need a clean paper trail connecting every dollar of the home equity loan to a rental-related payment.
The biggest mistake is depositing the proceeds into a personal checking account you also use for groceries, bills, and other spending. Once the money mixes with personal funds, proving which dollars reached the rental becomes genuinely hard. Open a separate account, park the loan proceeds there, and pay rental costs directly out of it. Keep the bank statements, wire confirmations, contractor invoices, and closing documents. Amounts and dates should line up with the disbursement.
The tracing rules also govern refinances. If you use a home equity loan to refinance debt already on a rental, only the portion that replaces the prior rental balance counts as rental debt. Any cash pulled out beyond that balance follows wherever you spend it. Spend it on rental improvements and the interest deducts; spend it on personal purchases and it doesn’t.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property
The $750,000 Cap Does Not Reach Rental Interest
Homeowners who itemize can deduct personal mortgage interest only on the first $750,000 of acquisition debt used to buy, build, or improve a primary or second home ($375,000 if married filing separately). The One Big Beautiful Bill Act, signed in July 2025, made this limit permanent; it had previously been scheduled to revert to $1,000,000 in 2026.5Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
That cap is largely irrelevant to rental investors. Interest that qualifies as a rental business expense is reported on Schedule E and is not subject to the acquisition debt limit, which governs only personal residence interest claimed on Schedule A. Say you have a $600,000 primary mortgage and take a $200,000 home equity loan to buy a rental. You are over $750,000 on paper, but the $200,000 rental portion is not counted against that limit because it comes off separately as a business expense.6Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss
The cap still bites on any part of the loan you spent on your own residence. That portion falls under the $750,000 limit and goes on Schedule A, while the rental portion goes on Schedule E. Clean tracing records are what let you split the interest correctly.
Where the Interest Goes on Your Return
Rental interest belongs on Schedule E (Form 1040), line 13, under “Mortgage interest paid to financial institutions.” Your lender’s Form 1098 will show the total interest for the year, but the address on that form is usually your primary residence, not the rental. You have to allocate the correct portion to Schedule E yourself, based on your tracing records.
If the entire home equity loan went to the rental, the full 1098 interest amount goes on Schedule E. If you split the funds, only the rental percentage lands there. The personal share can still deduct on Schedule A if you used it to buy, build, or substantially improve your primary residence and stay within the $750,000 cap. Personal use for anything else, such as paying off credit cards or buying a car, is not deductible anywhere.5Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
When your Schedule E figure does not match the 1098 because you split the interest, attach a statement explaining the allocation. That heads off confusion when the IRS cross-references the 1098 data against your return.
Points and Closing Costs Are Treated Differently
Points paid on a loan used for your primary residence can sometimes deduct in full the year you pay them. That shortcut does not apply when the proceeds go to a rental. You have to spread the deduction evenly over the life of the loan.7Internal Revenue Service. Topic No. 504, Home Mortgage Points Pay $3,000 in points on a 15-year home equity loan used for a rental, and you deduct $200 each year.
Other charges you pay to secure the loan, such as mortgage commissions, abstract fees, and recording fees, are not deductible as interest. The IRS treats those as capital expenses that become part of your cost basis in the property.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property Miscategorizing these is a common audit trigger because the tax treatment differs so much between interest-type charges and closing costs.
Passive Activity Rules Can Defer the Deduction
Qualifying the interest as a rental expense does not guarantee you can use all of it this year. The IRS classifies most rental real estate as a passive activity, and losses that exceed rental income face restrictions.8Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited If your rental expenses (interest, depreciation, repairs, insurance) exceed rental income, the resulting loss generally cannot offset wages, business income, or investment gains. Unused losses carry forward and become usable when the rental produces income or when you sell.
The $25,000 Special Allowance
Smaller landlords get an important carve-out. If you actively participate in managing the rental, meaning you approve tenants, repairs, and rental terms, you can deduct up to $25,000 in passive rental losses against non-rental income each year. The allowance phases out as modified adjusted gross income rises above $100,000, shrinking by 50 cents for every dollar over that threshold, and disappearing at $150,000.9Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules Active participation is a lower bar than material participation; you can hire a property manager as long as you retain authority over major decisions, and you must own at least 10% of the property.
Real Estate Professional Status
Taxpayers who qualify as real estate professionals can treat rental losses as non-passive, sidestepping these limits entirely. Qualifying means more than 750 hours during the tax year in real property trades or businesses in which you materially participate, and those hours must be more than half of all personal services you performed across all trades or businesses that year.10Internal Revenue Service. Instructions for Form 8582 Full-time agents, developers, and property managers can meet both tests. Most people with a day job outside real estate cannot.
The Penalty for Getting It Wrong
Claiming a rental interest deduction on money you actually spent personally is not just a lost deduction. It can trigger an accuracy-related penalty of 20% of the resulting tax underpayment.11Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The penalty applies when the underpayment stems from negligence or disregard of the rules, and failing to trace loan proceeds falls squarely into that category.
Prevention beats defense. Keep the separate account, keep every receipt, and never mix loan proceeds with personal funds. If you realize afterward that your records are messy or your deduction was too large, filing an amended return before the IRS contacts you generally avoids the negligence penalty. A 20% add-on to the tax you already owe makes sloppy recordkeeping an expensive gamble.