Home-equity interest deduction Tax Talk by George Saenz • Bankrate.com

Dear Tax Talk,
I can't get a grasp on the correct answer: If I borrow against the equity in my home and use it to build a rental home, can I deduct the interest expense on the amount over the $100,000 home-equity debt limit? If the answer is yes, where is the interest expense deduction to be put on my tax return?

Could you expand on the ramifications of such borrowing and subsequent use of the proceeds so far as the tax deduction of the interest goes?! I am so frustrated in trying to understand the right way to treat this interest expense!
-- Peggy

Dear Peggy,
The general rule is: You can claim, as an itemized deduction, interest expense paid on a mortgage used to acquire your principal residence and a second home. You can also claim, as an itemized deduction, interest expense on an additional $100,000 in borrowings without having to justify the use of the borrowing. However, if you do use the additional borrowing for investments, or substantial improvements to your home or homes, you can increase the $100,000 limit but can also change the character of the interest expense and, therefore, where you claim the deduction.

You change the character by tracing the borrowing to the use of the funds. In your case, you want to use $100,000 or more to build a rental property. Hence the interest on this debt (even if it goes beyond $100,000) becomes deductible against the rental income.

Alternatively, you can claim the interest on $100,000 of the total debt as an itemized home-mortgage interest deduction and the remainder against the rental income. You might want to allocate some of the interest as an itemized deduction if the rental property does not generate sufficient income to utilize all of your deductions in the year.

Additionally you might want to claim the interest on the $100,000 as itemized during the construction period to avoid limitations on the deduction. However, you may want to open a separate bank account to simplify the tracing of the borrowing to the construction of the property.