Avoiding Coal in Your Stocking!

Home prices are up. In some locations there is a shortage of inventory. According to the National Association of Realtors the number of homes available for sale has reached a low not seen since 2003. Well, it looks as if the world did not come to an end in 2009, the housing/mortgage crisis was not prolonged, and things are looking very good for 2014.

With all of the good news consumers are feeling more confident about their employment and work security. As a result, some individuals may be tempted to tap into their new found home equity for purchases; perhaps a new automobile, a long delayed vacation, or debt consolidation.Today’s posting is about the deductibility of interest for a home equity loan. A home equity loan is a loan which is taken out for “reasons other than to buy, build, or substantially improve” the home. Additionally, a loan incurred to buy, build, or substantially improve the home, may also qualify as home equity debt. It is “for reasons other than” which may create a lump of coal for someone’s stocking.

Let’s look at an example of how tapping into the equity of a home is not deductible and may result in a lump of coal . . . and an audit of a tax return. The home has a fair market value (FMV) of $250,000, and the current balance on the original mortgage (home acquisition debt) is $215,000. Fly-by-night Bank offers a home mortgage loan of 125% of the FMV of the home, less any outstanding mortgages. In order to consolidate debts, a $53,750 home mortgage loan [(125% × $250,000) — $187,000] is secured with the bank.

A tax return is filed claiming the full amount of interest charged as a result of the $53,750 home equity loan. The return is audited. The excess interest deduction is disallowed by the Internal Revenue Service and penalties, interest and taxes are due.

The amount of the home equity debt, which generates tax deductible interest, is limited to $35,000, and not $53,750. $35,000 is the amount that the FMV of $250,000 exceeds the amount of home acquisition debt of $215,000. The lesson here is to not borrow more than the value of your home. Not only is this wise tax advice but wise financial planning advice.

 

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