How To Deduct Personal Interest With a Home Equity Loan

Many individuals and families use personal loans and/or credit cards to buy cars, finance private schooling, take vacations, etc.

If you are making significant payments on these kinds of debts, you know you can't deduct the “personal interest.” That means you are paying the interest portion with after-tax dollars (and perhaps at very high rates as well).

However, there is a way to convert your nondeductible interest payments into a deductible expense. You can only get this tax break if you own your own home.

Specifically, you can take out a home equity loan (in the normal way, from a bank for example) and use the proceeds to pay off your nondeductible debts. You will probably be paying at a lower rate, since many lenders are charging near prime on these loans. And the interest payments will be deductible even though you don't use the loan for anything connected with the house.

Of course, before you borrow against the equity in your personal residence, you should be certain that you actually get the tax deduction benefit. As always, there are various technical restrictions and limits that may apply, depending on your particular tax facts and circumstances.

First, the loan must be secured by your residence. That is, the lender must have a mortgage interest in it. Don't confuse so-called “home improvement” loans, which are just one type of personal loan, with qualifying “home equity” loans. The interest on an unsecured home improvement loan isn't deductible.

Second, the residence securing the debt must either be your principal residence (essentially, the home you live in most of the year) or a single second residence, for example, a vacation home which you use for at least part of the year.

Third, although, as noted above, home equity debt doesn't have to be used on the home, there are limits on the amount of debt than can qualify. Specifically, qualifying home equity debt can't exceed the lesser of (a) $100,000, or (b) your equity in the home (specifically, the fair market value of the home at the date of the loan reduced by the “acquisition debt,” generally, your first mortgage). For example, say a taxpayer takes out a first mortgage to buy a home worth $300,000. Later, when the first mortgage is still $200,000, but because of a downturn in the real estate market the value of the home has declined to $275,000, the taxpayer takes out a home equity loan to reduce his credit card debts and pay for his daughter's wedding. The taxpayer will only be able to deduct the interest on a maximum of $75,000 of any home equity loan he takes out ($275,000 fair market value minus $200,000 acquisition debt), even though the lender may be willing to make a loan in excess of the taxpayer's $75,000 equity in the home. Thus, if the taxpayer took out a $100,000 home equity loan, only 75% of the interest on the loan would be deductible.

Also, you should bear in mind that interest on a home equity loan isn't deductible for purposes of the alternative minimum tax (AMT), unless you use the loan to improve your home. This is an important consideration, since an increasing number of taxpayers are subject to the AMT.

As always, contact your tax professional.