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The Pros and Cons of Home Equity Debt
What you don't know could cost you

While most interest expense is no longer tax deductible, it is a viable deduction if the interest is on your primary or secondary residence. While limits apply, the use of a secondary loan on your primary or secondary residence can also qualify for interest deductibility. However, “home equity” loan interest can often lose its tax deductibility if you're not careful. Here is what you need to know.

Home Acquisition or Home Equity Debt?

The first thing to understand is whether the debt secured by your residence is considered "Home Acquisition Debt" or "Home Equity Debt" per the IRS.

Home Acquisition Debt: Home Acquisition Debt is debt used to purchase, or refinance a primary or secondary residence. It also includes debt used to substantially improve your property. Interest deductibility of this type of debt is limited to the fair market value of the property or a total Acquisition Debt limit of $750,000 ($375,000 if married filing separately). The interest expense is deducted as an itemized deduction on Schedule A of your 1040.

Home Equity Debt: Home Equity Debt is all other debt secured by your primary or secondary residence. Interest deductibility of this type of debt is limited to the fair market value of the property taken in conjunction with Home Acquisition Debt. Unfortuantely, new tax legislation now suspends this IRS defined home equity dept.

Home Equity Debt can still be deductible

While the IRS definition of "Home Equity Debt" is gone for now, you can still deduct the interest as Home Acquisition Debt if you use the loan or line of credit to buy, build or substantially improve a qualified residence. But this also means if you use the proceeds of this additional loan for any of the following reasons it is NO LONGER deductible;

  • Consolidating credit card debt
  • Financing college costs
  • Starting a business
  • Buying a car, boat or other major vehicle
  • Funding medical procedures

Home Equity Debt Pitfalls

If you are counting on using your Home Equity Loan interest as a tax deduction you will want to make sure you understand the pitfalls. All too often home equity loans and their related interest become a problem when:

  • The loan interest is disallowed because it is not secured by a main or second home.
  • The outstanding loan balance exceeds the fair market value of your house. When this occurs there is no longer equity to support the loan. Best case; you lose interest deductibility on your tax return. Worst case; your bank demands repayment of your home equity loan because your home no longer provides adequate collateral.
  • You decide to use your home as a home office or as rental property. In this case the interest becomes a business expense, not an itemized deduction.
  • Total Acquisition Debt exceeds $750,000 ($375,000 if married filing separate).
  • You refinance to pull out equity. This not only creates additional leverage on your property, it could cause you to surpass the home equity debt limit AND require the need to purchase mortgage loan insurance.

While Home Equity Debt as defined by the IRS is gone, loans secured by your home can still provide a valuable tax deduction. You must stay vigilant to the rules and understand your situation. Remember a default on a credit card doesn't necessarily risk losing your home, a default on your home equity loan could put you on the street.

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