As our children grow older, it seems their affiliated costs will proportionally multiply with their age, and as parents, we will assume these additional expenses. High school brings with it its own problems. With the expense of college looming on the horizon, there also can be some other costly expenses well before the college maneuver. If you’re planning on purchasing a car or truck, which almost always becomes necessary if they’re involved in high school sports or activities, then these expenses can add up. Personal loans for their auto or for the last vacation before they don’t want to be seen with you anymore, can be pre-tax interest black holes. Personal loans or credit cards used to buy these things has personal interest that can not be deducted. This means that you will be paying the interest portion with pre-tax dollars, never a good thing. There are ways to convert these loans and make the nondeductible interest deductible. You can restructure this debt and deduct the interest if you own your own home.
The easiest way is to take out a home equity loan or line of credit and use this cash to pay off your nondeductible debts. This money will be available at a lower interest rate usually closer to prime and the interest will be deductible. You don’t have to use the loan for anything related to your home to be able to deduct the interest paid. Before you borrow against the equity of your home, you should make sure that the tax benefits apply to your particular circumstance. It is always a good practice to seek professional advice to make sure that there are no technical or specific limitations concerning your personal situations.
- The loan must be secured by your residence.
- The loan must be secured by your principal home or a single vacation home.
- There are limits to the amount of debt that will qualify.
Although the debt doesn’t have to be used on your home, there are limits on the amount of debt than can qualify. Your qualifying properties equity debt can’t exceed the lesser of (a) $100,000, or (b) your equity in your home (specifically, the fair market value (FMV) of the home at the date of the loan reduced by the “acquisition debt,” or, your first mortgage). The following example is from the IRS publication “Home Mortgage Interest Deduction” publication 936.
You own one home that you bought in 2000. Its FMV now is $110,000, and the current balance on your original mortgage (home acquisition debt) is $95,000. Bank M offers you a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or other liens. To consolidate some of your other debts, you take out a $42,000 home mortgage loan [(125% x $110,000) – $95,000] with bank M.
Your home equity debt is limited to $15,000.
This is the smaller of:
- $100,000, the maximum limit, or
- $15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000.
It is also important to note that the interest on a home equity loan isn’t deductible for purposes of the alternative minimum tax (AMT), unless in this case you do use the loan to improve your home. This can be an important consideration, since an increasing number of taxpayers are subject to the AMT.
Even if you have already taken out a home equity loan or are just considering the possibility, it is advisable to have a tax professional look at all of the options and how they will effect you. We at garvey & garvey llc CPAs can easily assist individuals and business owners with establishing a method that is appropriate for them so there are no unwelcome surprises when there year end tax returns are filed.