Interest on home-equity loans not always deductible Low mortgage-interest rates made 2004 another big year for refinancing, and home-equity...

Share story

Interest on home-equity loans not always deductible

Low mortgage-interest rates made 2004 another big year for refinancing, and home-equity borrowing in the United States reached a record high.

Most Read Stories

Unlimited Digital Access. $1 for 4 weeks.

Americans took out $431.3 billion of home-equity loans and lines of credit, according to SMR Research, a market-research firm in New Jersey. That’s up 35 percent from 2003.

Yet many borrowers don’t realize they might not be able to deduct all the interest they pay on home-equity loans. That would depend on how much they borrowed and what they used the money for. Taxpayers subject to the Alternative Minimum Tax (AMT) face stricter limits on what they can deduct.

First, it’s important to know that in “tax-speak” there are two kinds of mortgage debt: home-acquisition debt and home-equity debt.

Acquisition debt is a mortgage or mortgages you take out “to buy, build or substantially improve” your main or second home. In general, you may deduct the interest you pay on up to $1 million in home-acquisition debt. The limit applies even if you own a second home.

So let’s say you took out a home-equity loan, and you used it to remodel your kitchen for $40,000. For tax purposes, that amount is considered part of your “acquisition” debt because it was used to improve the home. You can deduct the interest on that new debt, as long as your total acquisition debt is $1 million or less.

From the IRS’ standpoint, home-equity debt is different. It is money you borrowed from your equity and used for purposes other than buying, building or improving your home.

Only interest paid on $100,000 of equity debt is deductible as mortgage interest. Again, the limit applies even if you own a second home. If you used a home-equity loan to pay your child’s college tuition, for example, you can deduct only the interest you paid on the first $100,000. (Unless you are subject to the AMT; more on that in a moment.)

If you borrowed more than $100,000 and used it for purposes other than improving your home, you may still be able to deduct the interest if you used the money to invest in stocks or start a business, though it won’t count as mortgage interest paid. But if you spent the money on a vacation or a car, the interest is probably not deductible.

Things are trickier for those paying the AMT, the tax that mainly targets higher-income taxpayers. Those subject to AMT don’t get many of the write-offs that other taxpayers do. Only interest on mortgage debt that is used to buy, build or improve a home can be deducted. For more information, refer to IRS Publication 936, “Home Mortgage Interest Deduction,” or consult a tax adviser.

Marriage penalty

Like the AMT, the marriage penalty is something Congress has struggled with but not resolved. It arises when two people who have similar incomes marry. The result is that one spouse, instead of having part of her income taxed at the lowest rates, as a single earner would, sees her income simply added on top of her spouse’s, so her taxes begin at whichever bracket his last dollar was in.

On the other hand, couples with widely disparate incomes, or cases in which one has no income, get a marriage bonus.

Congress increased the standard deduction for married couples to twice that of single taxpayers, and expanded the lower brackets so that the range for married couples is double that for singles.

This reduced the marriage penalty for some lower-income couples — and increased the bonus for others. But many upper-income couples still would be better off, tax-wise, living in sin.

The alternative minimum tax

OK, you’ve done your return; you’ve taken all the deductions and credits you’re entitled to; you’ve taken advantage of the lower tax rates that have been in effect in recent years, and things aren’t looking too bad. So let’s get that bad boy in the mail and out of mind, right?

You may have to go back and do the whole thing again, using different rules. That’s because anyone whose income is much above $40,000 for a single or $58,000 for a couple and whose return goes much beyond W-2 wages and the standard deduction may be subject to the alternative minimum tax (AMT).

Originally put into the law to prevent wealthy Americans from using so many legal tax breaks that they ended up paying no tax, the AMT, thanks to inflation, has slowly but steadily broadened its reach down the income scale and into the middle class.

In simple terms, the AMT is a parallel tax system in which a number of benefits, such as personal exemptions and the deduction for state and local taxes, are eliminated; a special, large standard deduction ($40,250 for a single; $58,000 for a couple) is applied, and the tax is computed using two brackets of 26 and 28 percent.

A taxpayer is supposed to compute his or her tax the regular way and the AMT way and pay whichever is larger.

The AMT is full of traps all its own. For example, interest on a home-equity loan, which is deductible up to $100,000 for regular tax, is not deductible on the AMT unless the money was used to buy, build or improve your home.

Depreciation recapture

In recent years, homeowners and small-business owners have been treated to special tax breaks that can be extremely beneficial. Homeowners who sell now are allowed to exclude from tax large amounts of profit if their houses have appreciated, as many have.

Under the rules, up to $250,000 for a single taxpayer and $500,000 for a married couple is free of federal, and in many cases state, income tax.

Owners of small businesses have been granted big write-offs on the purchase of equipment, including big sport-utility vehicles. But home and business owners alike must be careful. If a homeowner has taken depreciation, such as for a home office or rental unit since 1997, those amounts are not exempt from tax, and are subject to a special tax rate of as much as 25 percent.

Likewise, if you’re a business owner who bought a big SUV in the past couple of years and wrote the entire cost off under the provisions that were then in effect, your “basis” is now zero.

Basis is the tax term for the amount you subtract from what you receive when you sell an asset in order to calculate whether you have a gain or loss.

The basis is typically the purchase price plus commissions for assets like stocks, but when you take depreciation deductions, as you can on business equipment, your basis goes down.

Thus, if you sold your big SUV, the money you got for it could be taxable.

For example, if you sold your big $75,000 SUV for $50,000, you would not have a $25,000 loss but a $50,000 gain — if you wrote the whole purchase price off your taxes in the year of purchase.