Look beyond mortgage tax deductibility

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Dear Dr. Don,
I own outright a home in California that has a value of $400,000. To buy it for cash about one year ago, I took out a home equity loan on my currently rented home in Phoenix. I owe $225,000 on that loan and the mortgage rate is currently at 3.25 percent.

I want to take a regular home loan on my California home. From my understanding, I am not able to have a tax deduction of the home equity interest, but I can deduct the interest on a first mortgage.

I want to pay off the loan in five years, so my plan is to get a 5/1 adjustable-rate mortgage to pay off my home equity loan on the Phoenix home. My credit score is 771 and I am currently employed, but my wife’s credit score is lower, probably in the mid-600s.

With the current low loan rates, I can get a 5/1 ARM at 3.8 percent annual percentage rate — which, after tax deductions, makes this attractive. Does this logic sound right? Can you give me some information on what product would work for us?
— Ira Interest

Dear Ira,
If I were you, I’d pony up for some professional tax advice (which this is not). If you’re renting the Phoenix home, the interest expense associated with the second mortgage on that investment property should be deductible as a business expense.

For additional information, see “Rental Expenses” in IRS Publication 527, “Residential Rental Property,” and IRS Publication 535, “Business Expenses.”

Once you get the deductibility issue settled, move on to the decision as to whether you want to pay off the home equity loan by getting a new mortgage on either the Phoenix property or your California residence. (A little tax planning can help here, too.)

When making this decision, ask yourself a couple of questions: How long do you plan to keep the Phoenix house as a rental? How comfortable are you with the current home equity loan’s terms versus the terms on a new mortgage?

If you still plan on paying off the note in five years, a 5/1 ARM can make sense. But you need to determine whether there’s a prepayment penalty on the home equity loan, and get an estimate on the closing costs on the new mortgage loan. Both will raise the cost of restructuring your mortgage debt.

Remember, if the interest expense on the home equity loan is deductible, you’ve got a lower effective rate on the existing home equity loan — you just have to balance that against the prospect of rates rising over your five-year planning horizon.

I may have raised more issues than I solved with this reply, but you want to minimize the total interest expense and to do that, you have to consider more than just the deductibility of the interest expense. Also consider closing costs, prepayment penalties, holding periods and the possible impact of interest rate adjustments.

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