|Home equity loan interest is deductible
-- to a point
It pays to read the small print -- especially when it reads: "Consult
your tax adviser."
Those words accompany
almost every home equity loan or line of credit solicitation for
good reason. Tax regulations allow many people to deduct all or
part of the interest they pay on these loans, but there are exceptions.
Because of these potential pitfalls, experts say people should educate
themselves before borrowing against their homes.
"If you have the option to take a home equity
loan vs. going out and borrowing money at a higher rate which is
not deductible and buying a car, then of course the home equity
loan is going to be better," says Sandra Raiter, a tax analyst with
the tax preparation firm Jackson
Hewitt Inc. in Virginia Beach, Va.
At the same time, Raiter says, "People would
get home equity loans -- you see the ads with the football star
saying, 'Get a home equity loan and pay off your credit card bills'
... and then continue to charge on their credit cards.
"It's not something to be done lightly."
Making a move
Thanks to changes in the tax laws dating back to 1986, many people
can benefit by moving debt with non-deductible interest -- such
as auto and motorcycle loans and credit cards -- over to a tax-deductible
loan or line of credit secured by a home. The tax advantage has
the effect of lowering the already low equity loan rate even further,
making credit cards look like a pretty silly way to manage debt.
"For home equity, you can deduct the interest
on a loan up to $100,000 regardless of where you use the money,"
says Thomas Langdon, a certified financial planner and tax professor
American College in Bryn Mawr, Pa. "Let's say your children
are going to college and you need extra cash. You can take a home
equity loan of up to $100,000 and deduct the interest payments on
The limit applies regardless of whether a borrower
has one $100,000 equity loan against a primary residence, or a combination
of loans worth that much but secured against two different homes.
Tighter tax restrictions apply to borrowers who take out home equity
loans that, along with a first mortgage, raise the debt to a level
above the value of the property.
In such circumstances, borrowers can deduct
the interest on only part of home equity debt. The
Internal Revenue Service determines the eligible debt by subtracting
the amount borrowed to acquire the property -- the first mortgage
-- from the fair market value of the home.
A homeowner with a $100,000 property and an
$80,000 first mortgage, for example, might be able to get an equity
loan for $45,000 under a 125 percent loan-to-value program. But
the house is worth only $20,000 more than the original debt, so
only the interest on the first $20,000 of the home equity debt is
deductible, according to Ron Kotick, a tax specialist with tax preparer
H&R Block Premium in West Palm Beach, Fla.
Langdon notes that equity loans used for home improvement qualify
for different treatment, however. They resemble first mortgages
for tax purposes. And since people can deduct interest on $1 million
worth of first mortgage debt, they have greater leeway than those
who use their equity loans for things besides a new deck or garage.
"It's called 'acquisition indebtedness' -- a
loan you get to build your house, a loan to buy your house, or any
loan you take out to substantially improve your home," says Roxanna
Pletchan, a certified financial planner with Lassus
Wherley & Associates in New Providence, N.J.
For instance, someone with a $400,000 first
mortgage who added a bedroom wing for $200,000 could deduct all
the interest paid. A similar borrower who used the $200,000 loan
for college expenses, on the other hand, only could deduct the interest
paid on the first $100,000 of the balance.
-- Updated: Feb. 1, 2002