Rules to deduct interest on home equity loan

Money Talk

Your Money

March 21, 2004|By MATT LUBANKO

I HAVE a home equity loan with a balance of around $35,000. Can I deduct the interest from this loan? And does the claim of this deduction in any way depend on how I used the money I borrowed?

- J.B., Baltimore

To be considered deductible, the Internal Revenue Service says, home equity loans must be secured by your home, taken out after Oct. 13, 1987, and not be so-called "home acquisition debt," which we will explain below.

If you meet those three requirements, then the question becomes how much interest on the loan you can deduct. Limits on the home equity loan interest deduction vary greatly, and they depend on your filing status, the value of your home minus your primary mortgage, or so-called "acquisition debt," and whether you used the loan for business or investment purposes.

In the simplest cases, the deductibility threshold is fairly easy to understand. If you're married and filing separately, only the interest on the first $50,000 of a home equity loan may be deducted.

If you're single or married and file a joint return, you may deduct interest on the first $100,000 of your home equity loan, according to the Internal Revenue Service in Publication 936.

But, if your home has lost value after you bought it, or if your mortgage balance nearly equals the value of your home, an additional rule might come into play.

To see this rule in action, let's assume your home is worth $200,000. Let's also assume the balance of your so-called "home acquisition" mortgage (or first mortgage) stands at $170,000. Under these aforementioned circumstances, you would be able to deduct interest only on the first $30,000 of your home equity loan.

Subtract the outstanding balance on your home acquisition mortgage from your home's fair market value to see if, and to what degree, this ceiling rule might apply to the eligible deductible interest on your home equity loan.

Special considerations also are made for people who use home equity loans for business or investment purposes.

In one twist in the law, one can take advantage of the so-called "election-out" rule. To travel this route, you have to attach a statement to your tax return in the tax year in which the loan was taken out.

"An election-out statement basically tells the IRS the home equity loan wasn't really a home equity loan," said Joel Kosovsky, a certified public accountant in Farmington, Conn. "It was a loan taken to finance a business or an investment."

An election-out statement can raise the limits on deductible interest on home equity debt (above $100,000 for single or married taxpayers who file a joint return, or above $50,000 for married taxpayers who file separately). And if the home equity loan was used to finance a business, the interest deduction sometimes can be claimed on Schedule C (the tax form for sole proprietorship businesses) instead of Schedule A (itemized deductions).

But if the loan was used to finance investments - in stocks or bonds, for example - "the one-year interest deduction cannot exceed the combined yearly interest, dividend or capital gain income from the investments," Kosovsky said.

To learn more, download IRS Publication 936: Home Mortgage Interest Deduction from the www.irs.gov Web site, or look it over at your local public library. J.K. Lasser's Homeowner's Tax Breaks: Your Complete Guide to Finding Hidden Gold in Your Home by Gerald L. Robinson also might prove helpful.

I am 44 years old. If I use money withdrawn from my 401(k) plan to help pay for my child's college education, would the IRS waive the premature withdrawal penalty?

- J.H., Old Saybrook, Conn.

No. Even when you use the money withdrawn for something as noble as a college education, there are two costs to consider when pulling money out of a 401(k) plan.

Because you're younger than age 59 1/2 , you likely would pay a 10 percent premature withdrawal penalty. And, unless your 401(k) plan was partially or fully financed with income on which you've already paid taxes, the withdrawal would be taxed as regular income, said Dianne Besunder of the New York IRS office.

Matthew Lubanko is a financial columnist for The Hartford Courant, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune. com.

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