Save Taxes with Home Equity Loans
Home equity loans can offer a number of tax-saving opportunities as long as you follow the rules. Home equity indebtedness usually generates fully deductible qualified residence interest. Home equity indebtedness is debt, other than acquisition debt (generally your first mortgage or a refinancing of that mortgage), secured by a qualified residence and not exceeding the lesser of (1) $100,000 ($50,000 for married filing separately), or (2) the fair market value (FMV) of your residence less acquisition debt. As a practical matter, this FMV cap should not come into play if a prudent third party makes the home equity loan. However, some lenders may offer home equity loans exceeding 100% of the value of your residence. For these loans, interest allocable to the debt in excess of your home’s FMV cannot be deducted as mortgage interest.
The cap on the debt and the requirement that it be secured by a qualified residence are the only restrictions applying to home equity indebtedness; actual use of debt proceeds is irrelevant. Also, there is no restriction on the number of qualified home equity loans you may have.
Using a home equity loan to finance personal expenses often results in an after-tax borrowing cost that is better than a credit card or unsecured bank loan. Home equity loan proceeds can also be used to purchase an automobile. While interest rates on auto loans are generally lower than rates for unsecured borrowing, the interest is generally not deductible for tax purposes unless the vehicle is used in a trade or business.
While you can generally treat interest expense from up to $100,000 of home equity debt as qualified residence interest, sometimes the debt proceeds are used so that the interest is fully deductible apart from being qualified residence interest [e.g., when used in a Schedule C (sole proprietorship) business activity]. In these cases, it is generally better to elect out of home equity treatment and treat the interest as a business expense. Possible benefits include a reduction in (1) self-employment taxes and
(2) adjusted gross income (AGI) for purposes such as the passive loss allowance for rental real estate, the itemized deduction phase-out, and other AGI sensitive items.
Example: Electing Out of Home Equity Debt Treatment. Howard takes out a home equity loan for $50,000. He deposits the loan proceeds into a bank account used by his sole proprietorship business. The money is immediately spent on new equipment for the business. Therefore, the interest expense from the $50,000 loan is fully deductible as business interest on his Schedule C. The interest expense reduces his regular and self-employment tax. It also decreases AGI, which may increase AGI sensitive deductions and credits. If Howard treats the $50,000 loan as home equity debt, the interest will be deductible as an itemized deduction for regular tax subject to the itemized deduction phase-out rules. Therefore, Howard should elect out of home equity debt treatment and treat the interest as a business expense.
Planning Point: Homeowners can consolidate part or all of their personal borrowing by obtaining a home equity loan. If properly structured, this recharacterizes nondeductible personal interest expense to deductible qualified residence interest, thus generating tax savings. However, any up-front costs of obtaining the loan must be considered.