Article: Home Equity Loan Not Always the Best Financing Source


	Gerry Henderson

March 2006

Home equity loan not always the best financing source

When purchasing income-producing assets, alternatives to your home equity line of credit may be the way to go

Because interest expense on home equity loans is, within limits, deductible without regard to the use of the debt proceeds, and because it generally carries a lower interest rate, home equity debt (instead of traditional consumer debt) is often used by homeowners to finance purchases of personal property.

There are instances, though, in which it may actually make sense not to use your home equity line of credit. Before we discuss those instances, though, let’s cover some home equity loan basics.

Home equity indebtedness generates fully deductible qualified residence interest. Home equity indebtedness is debt, other than acquisition debt, secured by a qualified residence and not exceeding the lesser of (a) $100,000 ($50,000 for married filing separately), or (b) the fair market value (FMV) of the residence less acquisition debt (including pre-October 14, 1987, grandfathered acquisition debt).

As a practical matter, this FMV cap should not come into play if a prudent unrelated party makes the loan. However, some lenders may offer home equity loans exceeding 100% of the value of the residence. For these loans, interest allocable to the debt in excess of the home’s FMV cannot be deducted as mortgage interest; instead, the tracing rules will determine whether such interest is deductible.

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 generally irrelevant. (Caution: The loan interest is not deductible if the deduction is barred by another statutory rule. For example, the interest on home equity debt is not deductible if the proceeds are used to purchase tax-exempt securities. Also, interest on home equity loans is generally not deductible for AMT purposes.

Using a home equity loan to purchase a personal use automobile. John and Karen have decided to purchase an automobile. The car they selected costs $42,800, and they will pay $5,860 down. The dealership offers a five-year loan at 7.75% interest. Karen found they could obtain a no-fee five-year home equity loan from their bank for 8.25%. They intend to pay off the loan in five years, and interest on both rates is compounded monthly. Assuming John and Karen’s combined federal and state income tax rate is 36%, which loan should they take?

The home equity loan results in the lower after-tax interest rate, 5.28% [8.25% × (1.0 – 0.36)]. Although the payments on the home equity loan would be more than on the dealership loan, deducting the home equity loan interest will result in a net cash savings to John and Karen.

Financing a vacation home with a home equity loan. Sometimes it makes sense to purchase a vacation home (that will be partially rented out during the year) with a home equity loan rather than acquisition indebtedness. Although interest paid on a mortgage for a second residence (vacation home) is deductible, the portion allocable to the property’s rental offsets rental income. On the other hand, if the interest is on a home equity loan (up to $100,000 maximum), it is deductible as an itemized deduction without regard to the use of the debt proceeds. Thus, none of the interest reduces rental income.

For vacation home owners, using a home equity loan to finance the property may offer the following advantages:

If the Section 280(A) vacation home rules limit rental deductions, deducting the interest as an itemized deduction can increase overall deductions because it does not reduce the rental income, so other rental deductions can be claimed instead.
If the property is considered a rental property, the interest allocable to personal use is not deductible; however, if the interest is home equity interest, it is fully deductible.
If the property is treated as a rental and the interest is not treated as a rental expense (deducted as home equity interest instead), the rental may produce net income, which would be passive income that can be offset by passive losses from other sources.

Example: Harvey plans to buy a vacation home for $100,000. The property will be treated as a rental because his personal usage will not exceed the greater of 14 days or 10% of the days it is rented at a fair rental. He plans to finance the purchase with a $90,000 mortgage secured by the vacation home. Because of its rental status, the interest on the loan allocable to the rental use will be a rental expense for computing the property’s income or loss (normally passive).

If Harvey uses a home equity loan to purchase the vacation home, the interest would be deductible as an itemized deduction rather than a rental expense. Thus, he has less rental expense, and the property will generate either a smaller passive loss or, possibly, passive income.

The downside to using a home equity loan is that:

the taxpayer is using his or her home equity to replace a loan that generally generates deductible interest;
interest on a home equity loan is deductible only to the extent of $100,000 of debt; and
the interest is deducted as an itemized deduction rather than as a deduction that might reduce AGI (and thus increase other AGI-sensitive deductions and credits). For high-income taxpayers, certain deductions will be disallowed when AGI exceeds the applicable threshold; for them, applying interest expense against rental revenue could be more advantageous than claiming it as an itemized deduction.

Forgoing home equity debt treatment to maximize interest deductions. While taxpayers can treat interest expense from up to $100,000 of home equity debt as qualified residence interest, sometimes the debt proceeds are used so that the interest is fully deductible apart from being qualified residence interest (e.g., when used in a Schedule C business activity). In these cases, it may be better to treat the interest expense under the general tracing rules rather than under the home equity debt rules.

Fortunately, taxpayers can irrevocably elect to treat debt as not secured by a qualified residence. The impact of this election is that the general tracing rules apply to determining the tax treatment of the interest expense. The election does not have to be made in the year the debt is incurred; instead, it can be made in that year or any subsequent year in which the debt is outstanding. Once made, the election is binding on all future years (as to that debt) unless the IRS consents to revoking the election. The election is made by attaching a statement to the return for the year of the election.

Electing out of home equity debt treatment by a taxpayer who otherwise would be able to deduct the interest above-the-line (via Schedule C, E or F) enables the taxpayer to “save” the $100,000 home equity debt benefit for another use. In addition, an above-the-line deduction allows taxpayers who do not itemize deductions to benefit from an otherwise unusable deduction. It may also shift the deduction from being an itemized deduction to one that decreases self-employment income, thus reducing self-employment tax.

Example: Howard takes out a home equity loan for $50,000. He deposits the loan proceeds into an account used by his sole proprietorship, a business in which he actively participates. The money is immediately spent on new equipment for the business.

If Howard uses the general tracing rules, the interest expense from the $50,000 loan is fully deductible as business interest on his Schedule C. The interest expense reduces his regular and self-employment tax. It also decreases AGI, which may increase AGI-sensitive deductions and credits. If Howard treats the $50,000 loan as home equity debt, the interest will be deductible as an itemized deduction for regular tax (subject to the itemized deduction phase-out rules). Furthermore, Howard will have used $50,000 of his $100,000 home equity debt tax benefit. Howard should elect to treat the $50,000 loan as not secured by a qualified residence, thereby allowing him to deduct the interest on his Schedule C. The election also preserves the availability of the full $100,000 home equity debt tax break for the future.

Caution: The regulations don’t state whether the election can be made for a portion of a debt without tainting the remaining debt. Thus, it appears an election to treat debt as not secured by a qualified residence prevents you from claiming a qualified residence interest deduction for any interest related to that debt. For example, an election made for a home equity debt used 70% for a Schedule C business activity and 30% for purchasing a personal-use vehicle would apparently cause the interest allocable to the automobile purchase (30%) to be nondeductible personal interest expense because of the interest tracing rules. To avoid this unfavorable treatment, it’s a good idea to take out two separate home equity loans and then make the election only for the one used for business purposes.

Using home equity loans to convert nondeductible personal interest to deductible interest is undoubtedly a widely used and recommended tax saving strategy. Using home equity loans to maximize deductions for vacation homes may not be done as often, but it can be just as effective. And, when the loan proceeds of a home equity debt are used for business purposes, electing out of home equity loan treatment may well be the way to go. For guidance on how to apply these options to your situation, please contact your Schmidt Westergard & Company tax professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.