Incentives

Have you ever refinanced your home, used the proceeds for personal use, and then claimed a tax deduction for the interest? I have some bad news. The IRS limits the amount you can claim as an interest deduction for tax purposes.

You are not sure what I am talking about?

Don’t worry you are not alone. You see we all believe that the interest you pay for your home (mortgage and a HELOC interest) is tax deductible. I found out the hard way that this is not really the case.

When you refinance on your home and use the money for any reason other than home improvement, the IRS limits your deduction for interest. In some cases you won’t be able to claim the deduction at all.

The IRS does give you some tax benefit and call this the home equity indebtedness deduction.

All this simply means is that:

If you are married and file a joint return you are generally allowed to claim a deduction interest up to $100,000 of the funds you borrowed. If you file separate tax returns the limit is $50,000. I am only referring to one aspect of the deductions here which relates to refinancing or borrowing extra from your mortgage. There are other deductions and incentives so please consult your advisor.

Like everything in life they give you something and then take it away.

Let’s look at the following example to see how this works.

Let’s assume that you bought your home for $300,000. After a few years you currently owe $260,000 on your home.

You decide to refinance and take cash out for $30,000. You worked hard and though it would be the ideal time to cash out. Can you claim an interest deduction on the entire $30,000? Let’s assume the market value on your home the day you decided to take the cash out refinance is $320,000.

The IRS limits your deduction according to the following:

You need to do a second quick calculation to find out the difference between the market value of your home and the costs plus improvements. In this example your market value is $320,000 and the cost is $300,000 so the difference is $20,000. This means is that even though you are allowed to claim up to $100,000 the IRS limits this and tells you that you can only claim interest on $20,000. So if you borrowed $30,000 and used this for personal use, the tax deduction for interest can only be claimed on $20,000. The interest you paid on the other $10,000 is disallowed.

Now if the market value of your home has decreased below the cost of your home, you cannot claim interest on any of the $30,000 you borrowed. I have seen hundreds of clients caught up in this potential tax trap and most of them have their taxes completed by their tax accountants. So if you home is worth $290,000 today and the original cost is $300,000, the entire interest you paid on the $30,000 you borrowed cannot be claimed for tax purposes.

Now here is some bad news especially in this economy where home prices have fallen really steeply. If the value of your home is less than what you paid for it and you borrowed money from your HELOC for personal use, the IRS prevents you from claiming a tax deduction for the mortgage interest. Let’s say your home is worth $300,000. It is value at $285,000 today. You borrowed $30,000 from your HELOC for personal use. The interest paid on the $30,000 is not deductible for tax purposes. If you have claimed this deduction in the past or plan to claim this in the current year, please don’t. You could end up with penalties and extra fines.

How do you know if you are caught up in this tax trap?…

By signing up above we will send you a quick guide for reference purposes only.

I strongly recommend you contact your advisor or if you plan to refinance your mortgage, keep detailed records so you can claim the correct deduction.

If you have refinanced and used the proceeds for personal sign up above and we will give you access to a free mortgage tax guide with a checklist to see if you claimed more than you should in the past.

Please note that this article is for information purposes only and should not be considered tax advice of any kind. We take no responsibility for the use of this information. I strongly urge you to contact your tax accountant for more information specific to your situation.