Tax Considerations of Home Equity Loans

Tax considerations of home equity loans are important. Remember, the mortgage interest deduction applies only if mortgage interest is paid on a qualified residence. A “qualified residence” according to the IRS, can be either the principal residence of the taxpayer, or one other residence selected by the taxpayer. Therefore, the home mortgage interest deduction is limited to interest payments on two homes.

In order for a second home to be considered a qualified residence, it must:

Actually be a “residence”

Be used as a residence by the taxpayer

Elected by the taxpayer for purposes of the home mortgage interest deduction.

The question of whether a second home is a “residence” is almost identical to the question of whether a dwelling is a “principal residence”. The individual facts and circumstances of the situation govern whether a second property can be considered to be a “residence” for tax purposes. However, the following five types of properties can generally qualify as long as they contain sleeping space, toilet and bath facilities, and cooking or kitchen equipment:

House

Condominium

Mobile Home

Boat

House Trailer

Now, whether a dwelling is used as a residence is determined under IRC Section 280A(d)(1), which provides that a dwelling is used as a residence if it is used for personal purposes for more than 14 days out of the year, or at least 10% of the number of days for which the dwelling is rented at a fair market value amount, whichever is greater. In other words, if you buy a vacation home and you rent it out for fair market value for 200 days out of the year, you would need to use the home for personal use for 20 days out of the year, which would be equivalent to 10% of the time that you rented it out for. Personal use includes use by the taxpayer or any member of the taxpayer’s family. Therefore, a residence that is used by a family member can be treated as the second residence that is eligible to be selected as a qualified residence. However, if a family member uses your residence as their principal residence and pays you fair market rent, their occupancy of your property does not qualify as your personal use and, therefore, the dwelling is not a residence, but an investment property. In other words, if a family member rents from you, you cannot consider their occupancy of your property as being your own personal use of that property.

Not only does the property need to be a qualified residence, but the mortgage needs to be “Acquisition indebtedness” to qualify for the mortgage interest deduction. Acquisition indebtedness is any debt that is incurred by acquiring, constructing or substantially improving any qualified residence, as long as the debt is secured by that residence. In other words, if you buy a $500,000 qualified residence with a $400,000 mortgage, you can deduct the interest on that $400,000 mortgage because it is considered to be acquisition indebtedness. However, if you buy a $500,000 home for cash, and then take out a $400,000 mortgage three years later to go on a gambling spree in Las Vegas, you won’t be able to deduct the interest on the $400,000. The interest on “acquisition” mortgage debt is tax deductible up to $1,000,000 (or $500,000 for a married person filing a separate return). The interest on mortgage debt that exceeds $1,000,000 is not tax deductible.

Therefore, if you buy a $2,000,000 home with a $1,500,000 mortgage, you can deduct the interest on the first $1,000,000, but not the interest on the additional $500,000 that exceeds the first million.

Now, that rule is subject to the exception that the next rule gives you which is called “Home Equity indebtedness”. Home Equity indebtedness is any debt that is secured by a qualified residence that is not acquisition indebtedness. Home equity indebtedness is tax deductible up to $100,000 (or $50,000 for a married person filing a separate return). This is true even if the funds are used for personal purposes.

So, let’s go back to the example of the $500,000 home and the $400,000 of gambling money that you cashed out with a mortgage after three years of living in the home. Although you wouldn’t be able to deduct the interest on the $400,000 as home mortgage interest, you could deduct the interest on the first $100,000 of this money as home equity interest – even though you are using it for personal purposes. The interest on the rest of the $300,000 however would still not qualify for the mortgage interest deduction.

Also, in the example of the $1,500,000 mortgage, you could deduct the interest on the first million as home mortgage interest, and the interest on the next $100,000 as home equity interest. Only the interest on $400,000 of this $1.5mm mortgage would not be tax deductible.

That is due to the fact that the interest on home equity debt that exceeds $100,000 is not tax deductible as mortgage interest.

Here’s another example:

Tim lives in a $400,000 home and that he originally purchased last year with a mortgage of $100,000. If Tim refinances into a $250,000 mortgage he will receive $150,000 of cash. If Tim uses $50,000 of this money to purchase investments, and $100,000 of this money to buy a luxury car, Tim can deduct the interest on the $100,000 as home equity interest and he can deduct the interest on the remaining $50,000 as investment interest. If Tim uses the entire $150,000 for personal purposes, he would only be eligible to deduct the interest on $100,000 of these funds, and the interest on the remaining $50,000 would not be tax deductible.

The moral of the story here is to be careful what you use the money for if you are cashing out more than $100,000 of your home equity. If you use the funds for investment purposes, you should be able to claim this as investment interest to offset your investment income. However, if you use the funds for personal purposes, you are only allowed to deduct the interest on a maximum of $100,000 of home equity interest for personal use.

It should be noted here, that if you take out a new mortgage or refinance your existing mortgage and take cash out for the purposes of buying out a spouse or ex-spouse during a divorce settlement, the new mortgage is considered to be an acquisition mortgage and the interest on the entire mortgage up to $1mm, qualifies for the mortgage interest deduction.

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