Home Equity Indebtedness

You can deduct more than the interest on your mortgage from your taxes. You can deduct interest for home equity indebtedness. Home equity indebtedness is the second kind of mortgage interest defined under the tax code; the first is acquisition indebtedness. It includes any and every kind of borrowing secured by your residence that is not used to acquire, build or substantially improve that residence

Well, what does that mean? Home equity indebtedness typically includes your home equity loan or home equity line of credit. You might use this to buy furniture or other assets. It also includes the cash-out portion of a cash-out refinance, as long as the additional borrowing isnt used to improve the home substantially. Thats already covered in your acquisition indebtedness type of deductible mortgage interest.

Why make the big fuss over the difference between home equity indebtedness and acquisition indebtedness? The difference is critical, because interest on home equity indebtedness is deductible for only $100,000 of debt principal, while acquisition indebtedness is for $1 million of debt principal. The good news is that you get up to $1.1 million of total debt of these two kinds, for which you can write off interest.

One caveat: your home equity indebtedness, when added to acquisition indebtedness, cannot exceed the total value of the home when the loan is incurred--excess interest above the value of the residence would be non-deductible personal interest.

Now, you might think you are laughing all the way to the bank. However, heres where the alternative minimum tax (AMT) comes in. Home equity indebtedness deductions must be added back to income for AMT purposes as an adjustment item. Therefore, home equity indebtedness interest is not deductible at all for taxpayers subject to the AMT. So, dont go out and buy that high-end furniture just yet, until you have a tax professional crunch the numbers for you.

In the context of mortgage planning, the AMT makes it critical that clients structure their mortgage borrowing so it qualifies as acquisition indebtedness, which is subject to higher debt limits and no AMT adjustment.

Also remember, that to be eligible under acquisition indebtedness, the debt must be secured by the same residence that the loan will be used for. If funds are borrowed against a primary residence to buy a second, the debt will not qualify!

So, what if you have to refinance? Well, theres good news here. Under the tax code, if a mortgage was originally considered to be acquisition indebtedness, then any refinancing of that mortgage will continue to be considered acquisition indebtedness, but only to the extent of the original mortgage.

If you borrow more money than your existing mortgage amount, the additional borrowing will be treated like home equity indebtedness. This restriction will apply, regardless of what the additional borrowing was for, unless you can fully document that it was for a substantial improvement on the existing residence.

The rules around mortgage interest deduction are complex. As always, if you have any questions about how you should handle your specific tax situation, get professional advice.

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