or the vacation of a lifetime. It doesn’t matter what. The loan must be secured by the home.
• Often, when the value of the home increases dramatically or interest rates plunge, people refinance. When you refinance, your mortgage interest deduction is limited to the interest on the balance of the loan at the time of the refinancing plus that HELOC value of $100,000. For instance, your original loan was for $200,000 five years ago, and today the loan balance is $175,000. The house is now worth $400,000. You get a new 80 percent loan for $320,000 and include the points and refinance fees in the new loan, taking the balance to $325,000. Since the interest rates are lower, your payments don’t go up very much—but you’re able to pull out $145,000 in cash. Suppose this is the only loan on the house. You may deduct the interest on this part of the mortgage only:The $175,000 balance left on the original loanThe $100,000 allowable HELOCTotal: $275,000 Allowable Mortgage BalanceWhat happens to the interest on the other $50,000 ($325,000 loan, less the deductible mortgage value of $275,000)? Nothing. No deduction. No carryforward. Nothing. So please take this into account when refinancing. If you are ever audited, the IRS will catch this error and may go back for up to three years to recover taxes due.
• $1 million is the limit of the total amount of mortgage balance on which you may deduct interest. That, plus the $100,000 HELOC. So . . . in total, you may deduct mortgage interest expense on up to $1,100,000. This limit is not per house; it is for all the homes you might own. The IRS had a field day with this limit several years ago. They tested how well taxpayers were adhering to this rule by auditing taxpayers who owned property in Santa Barbara, California, particularly in the Montecito area. Estates in that area sell for millions of dollars. Most of the taxpayers who were audited ended up having taken the full mortgage deduction instead of limiting the interest expense to $1,100,000. Their tax professionals were furious at the IRS (uh, actually at themselves for getting caught in this major blunder). But . . . the law is the law.
• Yet another limit—unlike real property taxes, where you may deduct the property taxes on all your properties, you are only entitled to deduct the interest on up to two homes. So people who have multiple homes must pick the two homes producing the highest interest deduction for the year. Don’t worry, you may switch your choices each year. TaxMama suggests that you use the homes with the highest interest rate or highest total interest expense.
• One more limit—Alternative Minimum Tax (AMT) rears its ugly head. Take a look at the AMT form, Form 6251 (https://www.irs.gov/pub/irs-pdf/f6251.pdf). When you deduct any HELOC interest at all, you need to enter that amount on line 4.This is not an adjustment that your tax software will pick up automatically—most professional software doesn’t even pick it up. This entry must be made manually. (Though, if the software companies would just create an input field for HELOC interest, the software would be able to do this for you.)
• Can you get around these deduction limits by moving some of the interest to your office in home (Form 8829) or to the rental form (Schedule E) when you rent out space in your home? Nope. I thought it would be a terrific loophole and researched this. Sad to say, no matter where you try to move that interest on your personal residence(s), you are still limited to the acquisition debt + $100,000 or to the $1,100,000 total loan balance.
• To top it all off, if you managed to snag a loan with a really good interest rate, like 4 percent or less—a married couple probably won’t have enough interest expense to allow you to itemize in the first place. (Average US mortgage debt is around $156,000 [https://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/] × 4 percent = $6,240. Add in about $2,000 in property taxes and your potential itemized deduction is under $10,000, including state taxes. The standard deduction for a couple filing jointly is more than $12,000.)
Tip #48:
Finally, some good news—here’s how you can increase the deduction for mortgage interest after you refinance. Suppose you realized that you had $200,000 in equity that you could pull out of your mortgage. This is a great way to get your hands on some cash without having to pay tax on the earnings. You decided that you can use that money as a down payment on a rental property. There is a special provision (https://www.irs.gov/publications/p936/ar02.html#en_US_2014_publink1000229898) that lets you choose to treat that loan not as being secured by your home, but as a loan on the new rental property (deduct the loan on Schedule E). Or you can use that money to invest in your business (deduct the loan on Schedule C or on your business tax return). In any case, the money from the loan must go directly to the business account or property purchase escrow or seller. Try to make sure these funds never hit your personal bank account at all. If the funds must get deposited into your bank account first, consider opening a separate account that you only use for that property or business and deposit this money there. Under no circumstances should these funds get mixed in with your personal funds. Otherwise the IRS does something called “tracing.” They trace each check or debit that cleared after the deposit and treat that deposit as being spent on those things (like the dry cleaner, groceries, credit cards, etc.) instead of on your investment. You might want to consider sitting down with a tax professional who is experienced with this area of taxation to work out the details. And consider writing loan documents between yourself and your business or yourself and the rental property to make sure the transaction is kosher. A good real estate attorney can be worth the investment of a consulting fee to ensure you are able to claim these interest deductions in full.
Tip #49:
Often overlooked mortgage interest is the interest on your timeshares. Since most people do not own two homes, they are not subject to all that nonsense we talked about before. But while you may not own an actual vacation home, you probably own a timeshare. Those loans tend to run about ten or twenty years. That is considered a second home. You’re entitled to deduct the interest on it.
Very Special Tip #50:
Uh oh . . . the mortgage is not in your name. We started talking about this in Tip #38. You didn’t have enough credit to get the loan, so your parents are named on the loan and on the title. Technically you are not allowed to deduct the mortgage interest or property taxes since you don’t own the house on paper. You probably get a notice from the IRS each year saying that they don’t have a Form 1098 reporting any mortgage interest in your name, and you have to duke it out with them in the mail, year after year. But this is such a common phenomenon these days that there is a solution. (Tax professionals struggle with this problem. Many don’t know this definitive solution. They know there should be one, but don’t know what the solution is. Now you will know!)
• You are what is called an “Equitable Owner,” or “Beneficial Owner.” When you respond to the IRS, tell them that you are the Beneficial Owner under Treasury Regulation Treas. Reg. § 1.163-1(b) (https://www.law.cornell.edu/cfr/text/26/1.163-1) and the owner on the title will not be taking the deduction. (Feel free to read the regulation.)
• It might not be a bad idea to also get some paperwork drawn up. Have an attorney draw up a contract between you and the owner on the title, spelling out that you are the actual owner and that they just helped you out for credit purposes.
• Have a deed prepared showing the title in your name. Better yet, have your name added to the title with the named owner. (It’s not wise for the person who is responsible for the loan to be removed from title. After all, if you default on the payments, it’s their credit on the line. Without being on title, they won’t be able to get control of the house and they won’t be notified if you default on the loan.)
• If you ever face a tax battle, there’s a really good article about this topic in the Journal of Accountancy based on Tax Court cases that were won (http://www.journalofaccountancy.com/issues/2008/oct/equitableownerequalsdeduction.htm).