Q: I need to borrow money. With the increase in the equity of my home due to the significant increases in the housing market, a home equity loan seems to be the best option for me. I believe that interest on up to $100,000 of home equity debt is deductible. Can you clarify that point?
A: Interest expense is deductible unless it is classified as personal interest. Other classifications generally allow a deduction.
The tax law has a classification called home equity debt. A loan which is secured by your principal residence or one other residence, and which does not exceed $100,000, is home equity debt.
A deduction is allowed for “home equity debt” interest without regard to the use of the loan proceeds.
This appears to set you up fairly well for a tax deduction. Unfortunately, the 2017 tax changes suspended the home equity classification for tax years beginning in 2018 and ending in 2025.
The classification still exists in the law. It is merely asleep and will not awaken until 2026. However, don’t despair yet.
To paraphrase Robert Frost, tax planning means that we know that when our plans “would seem defied, we have ideas yet that we haven’t tried.” The Cat in the Hat also (sort of) said that.
Personal interest is not deductible. Investment interest is. So too is business interest. Also passive activity interest.
What has been lost is automatic qualification of home equity debt as deductible “qualified residence interest.” Automatic, as in it does not matter what you do with the money.
Until 2026, it matters what you do with the money. If you do the “right” thing, the interest remains deductible.
Until 2026, we just need to try different things. This starts by asking, what do you plan to do with this money?
Remodel my kitchen and build a new addition to my house, you say. You are a winner! The interest is now deductible qualified residence interest.
I thought you said it was not qualified residence interest until 2026, you say. No. I said it was not automatically qualified residence interest.
If you use the proceeds to improve your home, it produces qualified residence interest. There is an overall $750,000 loan limit, but I will assume you are not there.
What if you just invest loan proceeds in a mutual fund? You feel like you need some liquidity for a rainy day.
That’s OK too! Now you have investment interest. The deduction is allowed up to your investment income.
There may be a delay in claiming the deduction, depending on how much annual investment income you report, but you will eventually get the deduction.
What if you want to start a business, and you use the proceeds to fund the venture. Again, you win! This is business interest and is deductible in full.
There is a quirky new rule for this business interest, but if your average annual gross receipts do not exceed $25 million, you are quirk free.
What if a friend or relative wants to start a new business and you plan to invest. More interesting. Is this investment or business interest?
The answer depends on how the business will be organized. Plan to be an equity owner? There must be some entity in which you will own equity.
If organized as a “C” corporation, which may have two levels of tax, the interest on your loan is investment interest.
If organized as a “pass through entity,” or “PTE,” which might be a partnership or an “S” corporation, your interest classification follows the entity’s use of the loan proceeds.
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If the PTE uses your loan money to acquire business assets or to operate the business, your interest is business interest.
The PTE investment operates on the same principles as if you started and ran your own business. The tax law says the PTE’s business is also your business.
If you are not involved in this PTE business, your interest may be passive. This is not good as it can cause the deduction to be delayed.
There is a bunch of “if, then” statements in this column. Until 2026, a tax adviser must probe your specific situation to answer the home equity question.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque.