Beware of limits on home equity deduction

Dear Tax Talk,
I am considering a debt consolidation loan that would loan me an amount in excess of the equity in my home. The loan amount would be $25,000 and I currently have a mortgage of $170,000 with no equity. By establishing this second mortgage, would I receive a tax deduction for the interest on the second mortgage? My wife and I make $55,000 together. -- Blake

Dear Blake,
Only in this country would someone provide you a secured loan that is more than the value of the security. What these folks are banking on is that you have good credit, that the value of the home will appreciate to eventually cover the loan and that you're not willing to live on the street. In addition, the lender will probably charge you a higher interest rate.

Generally, interest paid on a second mortgage is deductible. But there are a few basic restrictions.

First, the second mortgage cannot exceed $100,000 plus the amount of any substantial improvements made to the home. For example, if you build a pool for $25,000 you can borrow up to $125,000 on a mortgage and deduct the full amount of the interest paid.

Another limitation is that you cannot deduct the home mortgage interest on home equity debt if you used the proceeds of the mortgage to buy securities or certificates that produce tax-free income.

Lastly, the combined mortgages cannot exceed the value of the home. In your case, as you have no equity, the interest paid on the debt consolidation loan is not deductible.

In reality, the lender is giving you a personal loan and is disguising it as home equity indebtedness. As the value of the home increases over the years, the amount of the second mortgage debt that qualifies as home equity debt will also increase so that eventually the debt will produce a deduction.