Interest on home equity loans not always deductible

Low mortgage interest rates made 2004 another big year for refinancing. And home-equity borrowing in the United States reached a record-high level last year, according to a recent study.

Americans took out $431.3 billion of home equity loans and lines of credit, according to SMR Research, a market research firm in New Jersey. That's up 35 percent from 2003.

Yet many borrowers don't realize they might not be able to deduct all of the interest they pay on home equity loans. That would depend on how much they borrowed and what they used the money for. Taxpayers subject to the Alternative Minimum Tax face stricter limitations on what they can deduct.

First, it's important to know that in ``tax-speak,'' there are two kinds of mortgage debt: home acquisition debt and home equity debt.

Acquisition debt is a mortgage or mortgages you take out ``to buy, build or substantially improve'' your main or second home. In general, you may deduct the interest you pay on up to $1 million in home acquisition debt. The limit applies even if you own a second home.

So let's say you took out a home equity loan and you used it to remodel your kitchen for $40,000. For tax purposes, that amount is considered part of your ``acquisition'' debt because it was used to improve the home. You can deduct the interest on that new debt, as long as your total acquisition debt is $1 million or less.

From the IRS's standpoint, home equity debt is different. It is money you borrowed from your equity and used for purposes other than buying, building or improving your home. Only interest paid on $100,000 of equity debt is deductible as mortgage interest. Again, the limit applies even if you own a second home.

If you used a home equity loan to pay your child's college tuition, for example, you can deduct only the interest you paid on the first $100,000. (Unless you are subject to the Alternative Minimum Tax; more on that in a moment.)

If you borrowed more than $100,000 and used it for purposes other than improving your home, you may still be able to deduct the interest if you used the money to invest in stocks or start a business, though it won't count as mortgage interest paid. But if you spent the money on a vacation or a car, the interest is probably not deductible.

Things are trickier still for those who must pay the Alternative Minimum Tax, the tax that mainly targets higher-income taxpayers, including more Silicon Valley households each year. Those subject to AMT don't get many of the write-offs that other taxpayers do. Only interest on mortgage debt that is used to buy, build or improve a home can be deducted by those subject to AMT. That means that if someone who pays the AMT spends $20,000 of her home equity loan on a car, the interest on that debt is not deductible, even if she has not exceeded the $100,000 equity debt ceiling.

For example, let's say you had a mortgage for $300,000 and you've paid it down to a balance of $280,000. You refinance that amount of acquisition debt, and also take out a $100,000 equity line of credit. You use $60,000 to remodel a kitchen and bathroom. Now you have $340,000 worth of acquisition debt ($280,000 + $60,000), the interest on which is deductible for both regular and AMT purposes. If the remaining $40,000 of the loan is used for something other than substantial improvement to the home, it is deductible for regular taxpayers, but not for AMT payers.

For more information, refer to IRS Publication 936, ``Home Mortgage Interest Deduction,'' or consult a tax adviser.