Consider using home equity loans to convert interest paid into a deductible expense
Posted On: 3-14-2017 | Posted By: WK Staff
Many individuals and families make significant payments on personal loans each year, and sadly, the interest payments made on these personal loans are not deductible. There might, however, be a way for you to convert this debt from a personal loan to a home equity loan so that the interest you pay becomes eligible for a deduction.
In a home equity loan, the home owner uses the equity of his or her home as collateral to borrow money. You can use the proceeds from your home equity loan to pay off your personal debts, and the interest you pay on the resulting home equity loan becomes deductible.
Before you consider borrowing against the equity in your personal residence, you should be certain that you will be able to recognize the tax deduction benefit. There are three different requirements that you must meet to qualify for the deduction.
1. The loan must be secured by your residence. This means that the lender must have a mortgage interest in the property. Be sure to avoid confusing certain types of personal loans like “home improvement loans” or “construction loans” with a home equity loan.
2. The residence securing the debt must either be your principal residence or a single second residence. Your principal residence is described as the home you live in for most of the year, and a single second residence is a home that you live in for at least part of the year, such as a vacation home. If you own more than one second residence, a home equity loan on only one of those properties would be eligible for the interest deduction, but you have the choice to pick whichever residence will fit your needs.
3. Although home equity debt does not need to be used on the home, there are limits on the amount of debt that can qualify. The qualifying home equity debt cannot exceed the lesser of $100,000 ($50,000 if married filing separately) or your equity in the home. Let’s look at an example:
A taxpayer takes out a first mortgage to buy a home worth $500,000, and 8 years later, she has paid down the mortgage to $375,000. Because of a downturn in the real estate market, the value of the home has decreased from $500,000 to $450,000.
The taxpayer knows that she has some personal debts she owes to the bank, so she decides to takes out a home equity loan to pay off those debts. She knows that home equity loan interest is deductible and wants to take advantage of the opportunity. Because the taxpayer has been such a good customer at the bank, the bank agrees to give her a $120,000 loan and uses her home equity as collateral for this debt.
At this moment, the taxpayer’s equity in the home is $75,000 – her equity is calculated by reducing the fair value of the home ($450,000) by the loan still outstanding ($375,000). The taxpayer will only be able to deduct the interest on $75,000 of her home equity loan, not on the full $120,000. In other words, only 62.5% of the interest she pays on this home equity loan is eligible for a tax deduction ($75,000 ÷ $120,000 = 62.5%).
You should keep in mind that interest on a home equity loan is not deductible for purposes of the alternative minimum tax (“AMT”) – a supplemental income tax required in addition to regular tax for certain individuals, corporations, estates, and trusts – unless you use the loan to improve your home.
Home equity lines of credit (HELOC) are also eligible for this deduction if all the above stipulations are met.
If you are curious to learn more about converting personal debt to a home equity loan, please contact your WK advisor at (573) 442-6171 or (573) 635-6196.