Planning with home-equity loans and mortgage refinancing.

• Author: Ellentuck, Albert B.
• Position: Tax planning

Homeowners should not overlook the opportunity to generate cash flow by using the equity in their residence. Not only are home-equity loans a relatively cheap source of financing (considering the after-tax effective borrowing rate), but also the repayment terms are often more generous than those on unsecured loans.

Benefits of Home-Equity Loans

Home-equity indebtedness generates filly deductible qualified residence interest. Home-equity indebtedness is debt, other than acquisition debt, that is secured by a qualified residence and does not exceed the lesser of $100,000 ($50,000 for married filing separately) or the fair market value (FMV) of the residence less acquisition debt (including pre-Oct. 14, 1987, grandfathered acquisition debt) (Sec. 163(h)(3)(C)). However, interest on home-equity debt is not deductible if the proceeds are used to purchase tax-exempt securities and is generally not deductible for alternative minimum tax (Sec. 56(e)).

Note: The IRS Office of Chief Counsel concluded in CCA 200940030 that interest on up to $1.1 million of purchase-money mortgage debt incurred to acquire, construct, or improve a personal residence can be classified as deductible qualified residence interest, even when the entire $1.1 million is from a single first mortgage. Effectively, the first $1 million of the first mortgage can be treated as acquisition indebtedness, and the next $100,000 can be treated as home-equity indebtedness even though there is only one debt (Rev. Rid. 2010-25).

The cap on the debt and the requirement that debt be secured by a qualified residence are the only restrictions applying to home-equity indebtedness; actual use of debt proceeds is irrelevant, unless they are used to purchase tax-exempt obligations. The home-equity debt category represents an exception to the general rule provided in Temp. Regs. Sec. 1.163-8T, which states that tracing the use of debt proceeds determines the tax treatment of interest expense. Also, there is no restriction on the number of qualified home-equity loans that the taxpayer may have.

Using a home-equity loan to finance personal expenses often results in an after-tax borrowing cost that is better than a credit card or unsecured bank loan. Home-equity loan proceeds can also be used to purchase an automobile. While interest rates on auto loans are generally lower than rates for other unsecured borrowing, the interest is generally not deductible for tax purposes.

With prudent planning...