July 12, 2010 in Home Equity

Dear Dr. Don,
I own my home outright and am debt-free. Uncle Sam is having a field day taxing the heck out of me. The property was appraised two years ago at $475,000. Although it is a single-family home, I have an in-law apartment as well as a legal apartment — both of which are vacant.

It’s a shame to have all that equity sitting there. My wife recently retired and I am the sole income provider at this time. I’m looking to borrow as much as I can afford to redo a kitchen and invest the rest. I know that I’m in great shape financially and very fortunate to be in this position at 58 years old. What are your thoughts?
— Jim Juncture

Dear Jim,
Owning your home free and clear prior to retirement is a sound life goal. You’ve gotten to that point and now you want to re-lever your investment in the home to invest elsewhere. Tapping the equity in your home to invest in other assets — whether in stocks, bonds, commodities or other real estate investments — can make sense if you’re looking to diversify investments and you have most of your wealth tied up in a home.

Still, there’s risk involved in the decision. You already have this money invested. It’s invested in real estate. Borrowing against the value of the real estate to invest in other assets won’t build wealth if you then suffer a loss on those investments. Plus, you’ll still have the loan payments.

If you wouldn’t buy stocks on margin (borrowing from your brokerage firm to invest), you shouldn’t be borrowing against the equity in your home to invest. And I’m definitely not suggesting you tap the home’s equity, invest in the financial markets and then leverage that investment with a margin loan to invest in more financial assets. Using your home’s equity and then getting a margin loan creates too much leverage.

In many real estate markets, a house was worth more two years ago than it is worth today. Regardless, you own your home free and clear, and you can choose to borrow against it if you want to tap the equity. Your ability to deduct the mortgage interest on your federal income taxes is illustrated in Figure A — “Is My Home Mortgage Interest Fully Deductible?” — in IRS Publication 936, Home Mortgage Interest Deduction.

Placing a renter in the unit provides income that can be offset by expenses. The rental unit can have an impact on the deductibility of the mortgage interest, but you’ll need to work with a tax professional if you’re using that approach.

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