* How is loan interest eligible for tax deduction?
(i) I bought a house just after I got married 3 years ago.
My existing mortgage balance is $60,000. I have just put
$20,000 into it using various credit cards. The house is
now appraised at $145,000. What are the loan interest
items eligible for tax deduction?
(ii) If I take out a $20,000 home equity loan to pay off
my credit card debt, would my interest deduction be
different?
(iii) If, in addition to (ii) above, I take out a $96,000
cash-out mortgage refinancing loan to refinance my existing
mortgage, and use the excess cash of $36,000 (ie $96,000
less $60,000) to improve my house. How would this affect
my interest deduction?
(iv) Assume that I don’t act on (ii) and (iii). Instead,
I take out a 110% home equity loan to pay off my credit
card debt of $20,000, and lend the balance of $79,500 to my
parents to buy a house. What would my mortgage interest
deduction be like?
.
.
Whether or not your home mortgage interest is fully
deductible depends on:
(a) the date you took out the mortgage. October 13, 1987
is the important date.
.
(b) the amount of the mortgage
.
(c) how you use the proceeds of the mortgage
.
.
Let’s consider your four scenarios.
.
Scenario (i)
————
Mortgage interest is fully tax deductible if a home
mortgage is home acquisition debt as defined by the IRS.
Home acquisition debt is a home mortgage that:
.
(I) you took out after October 13, 1987, and
.
(II) you used it to buy, build or substantially improve
your qualified home (your main or second home), and
.
(III) is secured by that home.
.
Your $60,000 mortgage satisfies conditions (I), (II) and
(III), and therefore the mortgage interest on the $60,000
loan is fully deductible.
.
Your credit card debt $20,000 is not home acquisition debt
because it does not satisfy condition (II) — you have not
stated whether the $20,000 was used to build or to
substantially improve your home — and condition (III).
Therefore your credit card interest is not tax deductible.
.
—- Sidebar —-
There is a limit on home acquisition debt. The total
amount you can treat as home acquisition debt at any time
on your main home and second home cannot be more than $1
million (or $500,000 if you and your spouse filing
separately). If your home acquisition debt exceeds the
limit, the maximum deductible interest is that charged on
$1 million (or $500,000 if you and your spouse filing
separately).
—- End of sidebar —-
.
.
Scenario (ii)
————-
The IRS defines another type of loan as home equity debt.
Home equity debt is a home mortgage:
.
(A) you took out after October 13, 1987, and
(B) does not qualify as home acquisition debt, and
(C) is secured by your qualified home (your main or second
home)
.
Your $20,000 home equity loan used to pay off your credit
card debt satisfies conditions (A), (B), and (C) above, and
therefore is home equity debt under the IRS definition.
Therefore the interest on your $20,000 home equity loan is
fully tax deductible. Note that for what purposes home
equity debt is used is not relevant.
.
—- Sidebar —-
There is also a limit on home equity debt. The conditions
are:
1. The total home equity debt on your main and second
home cannot exceed $100,000 (or $50,000 if you and your
spouse filing separately), and
.
2. your home equity debt + your home acquisition debt +
your [tag]grandfathered debt[/tag] must not yield a total sum that
exceeds the fair market value of your home (grandfathered
debt is simply mortgages you took out on or before October
13, 1987). See scenario (iv) discussion below for further
clarification.
—- End of sidebar —-
.
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Scenario (iii)
————–
Based on the conditions discussed in Scenario (i), the
entire $96,000 is home acquisition debt. Therefore the
interest on the $96,000 cash-out mortgage is fully
deductible.
.
Home acquisition debt + home equity debt = $96,000 +
$20,000 = $116,000, ie less than your home’s fair market
value of $145,000. Therefore the $20,000 home equity debt
is within the allowable limit, and so the interest on the
$20,000 is fully deductible.
.
.
Scenario (iv)
————-
Let’s set out the numbers:
.
.. Your home’s fair market value = $145,000
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.. 110% x $145,000 = $159,500.
.
.. Your existing mortgage balance = $60,000
.
Therefore your home equity loan = $159,500 less $60,000 =
$99,500
.
The $79,500 you lend your parents is not home acquisition debt for tax purposes as the house belongs to your parents, and the house is thus not your qualified home. Therefore the entire $99,500 is your home equity debt for tax purposes.
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Let’s recap the conditions for home equity debt:
(aa) it is taken out after October 13, 1987, and
.
(bb) it is secured by your home, and
.
(cc) it does not exceed $100,000 (or $50,000 if you and
your spouse filing separately), and
.
(dd) your home equity debt + your home acquisition debt +
your grandfathered debt must not yield a total sum greater
than your home’s fair market value.
.
Your home equity loan of $99,500 satisfies conditions
(aa), (bb), and (cc), assuming you and your spouse don’t file
separately. But it does not satisfy condition (dd) because:
.
home equity debt + home acquisition debt +
grandfathered debt = $99,500 + $60,000 + $0 = $159,500,
exceeding your home’s fair market value of $145,000.
.
Therefore your maximum eligible home equity debt under condition (dd) = $145,000 less 60,000 = $85,000.
.
Now the figures under condition (dd) look like this:
.
home equity debt + home acquisition debt +
grandfathered debt = $85,000 + $60,000 + $0 = $145,000
.
In other words, you are allowed to claim tax deduction for loan interest paid on only $85,000 of your $99,500 home equity loan.
.
Next, you have to test again to see if condition (cc) is satisfied. Now compare the result ($85,000) with condition (cc), ie $85,000 vs $100,000. Since $85,000 does not exceed the threshold of $100,000, the eligible home equity debt for tax purposes is the lower of the two, ie $85,000.
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Summary for scenario (iv)
—————————————
(1) The interest on your existing mortgage balance of
$60,000 is tax deductible.
.
(2) Of the $99,500 home equity loan, only $85,000 qualifies as home equity debt under the IRS definition, and the interest attributable to $85,000 is tax deductible.
.
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