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Taxes and your home equity loan

By John Stehmeyer

Real Estate Broker/Owner with Pro Players Realty

May 18, 2009 01:11 AM

By Kay Bell • Bankrate.com

A house is much more than just a shelter. For many homeowners, it serves as a private bank.

When structured properly, the money you can draw from the equity in your home can provide a nice tax break. In most cases, a homeowner can deduct interest paid on a home equity loan or home equity line of credit (HELOC) of up to $100,000.

The key phrase, however, is "in most cases." There are some deductibility limits. The alternative minimum tax also might also negate the benefits. So before tapping into the residential vault, homeowners should carefully evaluate their overall financial needs and tax situation.

Many uses, one big tax break
Home equity funds are often used to pay for home improvements, remodeling and renovations, college costs or consolidate personal loans and credit card debt. By leveraging the money already put into a house, an owner typically has access to larger sums of money to pay for these items.

And, of course, there is the tax advantage.

"When you talk about taxation and home equity, you primarily look at the deductibility of the interest," says Jim Hiles, a certified financial planner with CBIZ Wealth Management in New York. The tax law allows a borrower to deduct interest on a home equity loan or a combination of loans up to $100,000, regardless of how the money is used.

"It certainly is a popular way to pay," says Hiles, "if you can deduct the interest."

It's that "if" that trips up some home equity borrowers. Whether it can be deducted and exactly how much interest on a home equity loan is deductible depends on several factors.

Interest on $100,000 ... maybe
Most homeowners focus on the $100,000 amount that's usually touted as "deductible" in ads for home equity products. But borrowers also need to be aware of how their property's fair market value and any existing mortgage could affect the tax break.

When the combination of all loans secured by a home, including the first mortgage and any other equity loans, are more than the property's fair market value, the interest on the portion of debt that exceeds the home's value is not deductible.

For example, you have a $95,000 mortgage on your home, which is now worth $110,000. Your bank says you qualify for a 125 percent loan-to-value equity loan of $42,500 ($110,000 x 125 percent = $137,500 minus $95,000 left on your first mortgage = $42,500). Because your son has outstanding college tuition bills and you'd also like to buy him a car to get to and from school, you take the bank up on the offer, planning to deduct the interest on the equity loan on your taxes. It is, after all, well below the $100,000 limit.

Not so fast. This is where the value of your home comes into play. Tax rules say that in these circumstances, you can deduct interest on equity loans up to $100,000 or, when the total amount of all loans secured by a home is more than its fair market value, on the equity amount that does not exceed the property's value, whichever is less. In this case, that's $15,000 ($110,000 minus $95,000).

So, your tax deduction is limited to the interest on just $15,000 of your home equity loan. You can't deduct the interest on the remaining $27,500 of the equity loan even though it is secured by your home and well below the $100,000 limit.

Improved breaks for home improvement
"There is one loophole," says Hiles. "When an equity loan is used for home improvement, it gets a different tax treatment."

In this situation, the equity funds are essentially treated as first mortgages. In IRS terms, this is known as acquisition indebtedness.

"This is a loan that you get to build your house or substantially improve your house," says Hiles. "Adding on a second story or redoing the house counts as acquisition indebtedness. On these loans, you can deduct interest on up to $1 million in mortgage debt."

For instance, if you took out a $200,000 home equity loan to add an audio/video entertainment room to your $500,000 home, you could deduct all the interest paid on that loan. However, if you used that $200,000 to pay for a lengthy European vacation, you could deduct only the interest paid on the loan's first $100,000.

There's no requirement that you document how you spent your equity loan funds, but it's a good idea to hang onto receipts just in case. Hiles says comprehensive records could be crucial in ensuring that you keep your allowable acquisition-debt interest if you're ever audited.

Other equity loan considerations
Home equity borrowers also need to keep an eye on possible alternative minimum tax implications. This parallel tax system could cost some taxpayers their deduction.

Interest on acquisition-debt loans is still deductible under the AMT. However, money secured by your home but used for nonresidential purposes is disallowed.

The tax gap -- money the IRS says it is owed, but which taxpayers have not paid -- also could also pose some problems for equity-loan borrowers. Tax officials and members of Congress believe that improperly claimed home-related tax deductions have contributed to this collection deficit.

"They've announced that they may ask taxpayers to produce documents of original mortgage to verify that interest is indeed within the limit," says Marck Luscombe, principal tax analyst at CCH, a tax publisher and software provider. If the IRS finds that you've incorrectly claimed home equity loan interest, it will ask you to pay it back, along with penalty and interest charges.

Finally, keep in mind that while a home equity loan amount might seem relatively small, it still is secured by your residence. "At the end of the day, the bank wants its money back and your home is the collateral," says Hiles. "You could be forced to move out if you don't repay the debt."

This content was originally from BankRate.com

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