One of the biggest advantages that home equity loans offer is the deductibility of the interest rate. However, many debtors don't fully recognize the limitations that are set on these deductions and how proper allocation of such loans can qualify them for the deductions. There are two types of mortgage loan interests. The first one is the interest from home acquisition debt which is used to buy, build, or substantially improve a house. The second one is the home equity debt which is not used to buy or build a home. The intent and actual use of the loan dictates how the loan is treated for income tax purpose.
Debtors can deduct interest from home acquisition debt that is up to $1,000,000. However, they can only deduct interest from home equity debt that is up to $100,000. Borrowing $120,000 for debt consolidation will not allow the debtor to deduct the interest from the extra $20,000, unless the $20,000 is used to substantially improve a house.
Another limitation on the deduction of the interest rate can be seen when the value of the house drops. The interest rate can only be deducted from home equity debt that is not exceeding the owner's equity in the house. Therefore, if a debtor owns a house worth $300,000 and $250,000 is secured with a home acquisition debt and a debtor borrows additional $50,000 through home equity debt, the interest from the $250,000 and $50,000 would be deductible. But if the value of the house drops to $270,000 the interest on the $250,000 home acquisition debt would still be deductible, however only the interest from $20,000 (270,000-250,000) of the home equity debt would be deductible.
Debtors also have to consider whether they fall under the alternative minimum tax or the itemized tax regime. Only the itemized tax regime will allow debtor to deduct the home equity loan interest. Keeping this in mind, the tax factor may not apply to a debtor at all, and in this case it might make more sense to use other types of loans, instead of putting your house as collateral.
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