Planning With Home-Equity Loans and Mortgage Refinancing

Homeowners should not overlook the opportunity to generate cash flow by using the equity in their residence. Not only are home-equity loans a relatively cheap source of financing (considering the after-tax effective borrowing rate), but also the repayment terms are often more generous than those on unsecured loans.

Home-equity indebtedness generates fully deductible qualified residence interest. Home-equity indebtedness is debt, other than acquisition debt, that is secured by a qualified residence and does not exceed the lesser of $100,000 ($50,000 for married filing separately) or the fair market value (FMV) of the residence less acquisition debt (including pre-Oct. 14, 1987, grandfathered acquisition debt) (Sec. 163(h)(3)(C)). However, interest on home-equity debt is not deductible if the proceeds are used to purchase tax-exempt securities and is generally not deductible for alternative minimum tax (Sec. 56(e)).

Note: The IRS Office of Chief Counsel concluded in CCA 200940030 that interest on up to $1.1 million of purchase-money mortgage debt incurred to acquire, construct, or improve a personal residence can be classified as deductible qualified residence interest, even when the entire $1.1 million is from a single first mortgage. Effectively, the first $1 million of the first mortgage can be treated as acquisition indebtedness, and the next $100,000 can be treated as home-equity indebtedness even though there is only one debt (Rev. Rul. 2010-25).

The cap on the debt and the requirement that debt be secured by a qualified residence are the only restrictions applying to home-equity indebtedness; actual use of debt proceeds is irrelevant, unless they are used to purchase tax-exempt obligations. The home-equity debt category represents an exception to the general rule provided in Temp. Regs. Sec. 1.163-8T, which states that tracing the use of debt proceeds determines the tax treatment of interest expense. Also, there is no restriction on the number of qualified home-equity loans that the taxpayer may have.

Using a home-equity loan to finance personal expenses often results in an after-tax borrowing cost that is better than a credit card or unsecured bank loan. Home-equity loan proceeds can also be used to purchase an automobile. While interest rates on auto loans are generally lower than rates for other unsecured borrowing, the interest is generally not deductible for tax purposes.

With prudent planning, homeowners can consolidate part or all of their personal borrowing by obtaining a home-equity loan. If properly structured, this recharacterizes nondeductible personal interest expense to deductible qualified residence interest, thus generating tax savings for the taxpayers. However, any upfront costs of obtaining the loan must be considered.

While taxpayers can treat interest expense from up to $100,000 of home-equity debt as qualified residence interest, sometimes the debt proceeds are used so that the interest is fully deductible apart from being qualified residence interest (e.g., when used in a Schedule C, Profit or Loss From Business (Sole Proprietorship) , business activity). In these cases, it is better to treat the interest expense under the general tracing rules rather than under the home-equity debt rules. Possible benefits include a reduction in self-employment taxes and adjusted gross income (AGI), for purposes such as the passive loss allowance for rental real estate, the itemized deduction phaseout, and other AGI-sensitive items.

Under Temp. Regs. Sec. 1.163-10T(o)(5), taxpayers can irrevocably elect to treat debt as not secured by a qualified residence. The effect of this election is that the general tracing rules of Temp. Regs. Sec. 1.163-8T apply to determine the tax treatment of the interest expense. The election does not have to be made in the year the debt is incurred; instead, it can be made in that year or any subsequent year the debt is outstanding. However, once made, the election is binding on all future years (as to that debt) unless the IRS consents to revoke the election. The election is made by attaching a properly completed statement to the return for the year of the election.

Example 1: H takes out a home-equity loan for $50,000. He deposits the loan proceeds into an account used by his sole proprietorship, a business in which he actively participates. The money is immediately spent on new equipment for the business. As explained in the following paragraph, H should elect to treat the $50,000 loan as not secured by a qualified residence.

If H uses the general tracing rules, the interest expense from the $50,000 loan is fully deductible as business interest on his Schedule C. The interest expense reduces his regular and self-employment tax. It also decreases AGI, which may increase AGI-sensitive deductions and credits. If H treats the $50,000 loan as home-equity debt, the interest will be deductible as an itemized deduction for regular tax (subject to the itemized deduction phaseout rules). Furthermore, H will have used $50,000 of his $100,000 home-equity debt tax break.

Electing out of home-equity debt treatment by a taxpayer who otherwise would be able to deduct the interest above the line (via Schedule C, E, Supplemental Income and Loss , or F, Profit or Loss From Farming ) enables the taxpayer to "save" the $100,000 home-equity debt for another use. In addition, an above-the-line deduction allows taxpayers who do not itemize deductions to benefit from an otherwise unusable deduction. It may also shift the deduction from an itemized deduction to one that decreases self-employment income and self-employment tax.

Caution: The regulations do not state whether the election can be made for a portion of a debt without tainting the remaining debt. It appears an election to treat debt as not secured by a qualified residence prevents a taxpayer from claiming a qualified residence interest deduction for any interest related to the debt. Thus, an election made for a home-equity debt used 70% for a Schedule C business activity and 30% for household furniture would cause the interest allocable to the furniture (30%) to be a nondeductible personal interest expense. To avoid this unfavorable treatment, a taxpayer should consider taking out two home-equity loans and make the election for the one used for business purposes.

When a mortgage on a principal residence is refinanced, the interest expense on the new debt is deductible to the extent the new debt does not exceed the amount of acquisition indebtedness that was refinanced. The aggregate amount of all acquisition debt generally cannot exceed $1 million.

Points paid in connection with mortgage refinancing generally are not deductible when paid but, instead, must be capitalized and amortized over the term of the new loan (Rev. Rul. 87-22). Amortization is computed ratably based on the number of periodic loan payments made in the tax year to the total periodic payments for the term of the loan (Rev. Proc. 87-15).

Example 2: Assume that F refinanced his $150,000 mortgage on his principal residence in 2014. He paid two points ($3,000) out of his own funds at closing to do so (i.e., they were not withheld from the debt proceeds). The proceeds of the new loan were used to pay off the old loan. Since the old loan represented acquisition debt, the new loan is also treated as acquisition debt.

Since the loan proceeds were used for purposes other than purchasing or improving the residence, the points F paid on the new mortgage loan do not meet the requirements of Sec. 461(g)(2) and, thus, are not currently deductible (Rev. Proc. 87-15). Instead, they can be amortized over the term of the new mortgage.

If F had borrowed $200,000 and used $50,000 for improvements to his residence and the remaining $150,000 to refinance his old loan, 25% ($50,000 ÷ $200,000) of the points would be deductible. The remaining points would be amortizable over the term of the loan.

If the new loan is paid off before maturity (e.g., the residence is sold and the loan paid off, or the loan is refinanced), the remaining unamortized balance of the points can be deducted in that tax year, unless the mortgage loan is refinanced with the same lender, in which case the unamortized points generally must be deducted over the term of the new loan (Letter Ruling 8637058; IRS Publication 936, Home Mortgage Interest Deduction ). The points on the refinanced debt are then subject to the normal rules for points. Thus, if the refinanced debt is paid off early, any unamortized points can be deducted that year.

Also, provided the borrower paid an amount at least equal to the points at the closing of the first refinancing, if that loan is subsequently refinanced with a different lender, it appears that the unamortized points related to the first refinancing can be deducted in the year of the subsequent refinancing. This is similar to the rule that allows cash-basis taxpayers to deduct expenses that are paid with borrowed funds, as long as the funds are not borrowed from the provider of the goods or services that give rise to the expense.

Some refinancings may be treated as a continuation of the original purchase so that any points paid would be deductible in the year paid rather than amortized over the loan's life. In Huntsman , 905 F.2d 1182 (8th Cir. 1990), points were paid to refinance a three-year note used to purchase a principal residence. Because it was obvious the taxpayer would have to refinance, the court considered the refinancing transaction to be in connection with the purchase of the residence. This rationale should also apply to taxpayers who refinance a bridge loan or construction loan, at least within the jurisdiction of the Eighth Circuit. However, the IRS has stated that it will not follow the Huntsman decision outside the Eighth Circuit (Action on Decision 1991-02 (2/11/91)).

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 15th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2014 (800-323-8724; ppc.thomson.com).