The Epitome of a Tax Trap
August 2005
The tax code is so vague that most of you have only a general idea of what is deductible. However, we all are confident that one item is always deductible: home mortgage interest. In 1986, Congress imposed the first limitation on mortgage interest, limiting the deduction to interest on $1 million to acquire homes and an additional $100,000 of home equity. Other forms of interest (on loans to pay credit card bills, education, and cars) were designated non deductible personal interest. Since then, taxpayers have responded to all sorts of advertisements, using their home equity loans to fund vacations, pay their taxes, buy cars, fund college and pay credit card debt, converting non deductible personal interest into deductible home equity interest. Home equity indebtedness in the United States has reached the $500 billion levels, with everyone comfortable in the knowledge that as long as the loans do not exceed $100,000, the interest is deductible.
Guess what: for those of you subject to the alternative minimum tax, home equity may not be deductible. For AMT, you must add back home equity indebtedness interest unless the funds are used to buy, construct or rehabilitate a residence. As a result, interest on home equity indebtedness is not deductible when used to buy cars, refinance credit cards, pay for vacations or pay off your taxes. If you recall the May lunch byte, it is estimated that 33 million taxpayers will be subject to the AMT tax by 2010 and the home equity interest deduction is at risk for all of them.
The question then becomes what can be done to preserve the deductibility of home equity interest. We need to take more time to establish that home equity draws go to the qualified uses of buying, constructing or rehabilitating residences. We can also qualify the interest as deductible investment interest or passive interest if we can establish that the draw goes to purchase an investment or to finance a passive activity. The IRS has established complicated and extensive tracing rules to determine whether interest on loans is deductible or not for AMT purposes, but also grants a 15 day window on both sides of a loan draw where you can designate the use of that loan draw.
It can be as simple as this: you wrote a $5,000 check on April 10th to a contractor who built a basement addition. On April 15th, you then borrowed $5,000 on your home equity loan to pay your taxes. Here, you can designate the loan draw as funding the qualifying purpose of rehabilitating your residence and the interest is deductible for both regular and AMT taxes. Now changing the facts slightly, say you pay the contractor on March 20th and borrow the funds on April 15th for taxes. In this case, the loan is not within the 15 day window and the interest, while being deductible for regular taxes, would give you no benefit for AMT.
Don’t panic if you have failed to comply with these provisions previously, as IRS scrutiny of this issue is currently non existent. We have not received one inquiry from the IRS regarding the use of proceeds from a home equity loan or application of the $1 million threshold for home acquisition indebtedness. Further, as you repay debt, the proceeds are first applied towards non qualifying debt, so to some extent past mistakes are self correcting. For 2005, we want to take a step towards compliance. Our tax organizer will ask you to list percentages of the application of your home equity loans for passive, investment or home improvement. Please take care to insure that if you will use home equity, any expenditure for home improvements are accompanied by a timely draw and use available cash to fund personal expenditures.
Call Geoff Langdon at Cover & Rossiter (302-656-6632) with questions. Or, you can email us at
CoverRossiter@CoverRossiter.com.