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Home-equity debt interest deduction capped

ALBUQUERQUE, N.M. — Q: My wife and I own our house free and clear. We have three children that will be attending college beginning in 2014 and continuing through 2023, and I expect that we’ll hit some cash-flow holes when the kids start in college. With interest rates so low now, I am thinking about borrowing about $150,000 secured by the house. I’ll probably use some of the money to buy a new car, and then just sit on it until the kids start college. I want to confirm the tax consequences of the interest. IRS Tax Topic 505, which I found on the Internet, says that I can deduct the interest on $100,000 of the debt, but I can’t understand what happens to the rest of the interest.

A: The tax law allows you to deduct “acquisition” debt for a residence and “home equity debt.” Acquisition debt is debt used to purchase, construct or improve the home, and home equity debt is debt secured by the home but used for some other purpose.

Home equity debt may be used for any purpose, and you can deduct the interest on as much as $100,000 of such debt. If you borrow $150,000 secured by the home, interest on $100,000 of principal will be deductible without regard to how you use the loan proceeds.

Of course, it wouldn’t be fun if there were not exceptions. If you happen to be subject to the alternative minimum tax (AMT), the home equity interest deduction is not deductible for the AMT unless the proceeds are used for improvements.

This means that you may lose the interest deduction if you are already subject to the AMT, or you may be pushed into the AMT because of the home equity interest differences between regular tax and AMT.

But you have an interesting plan, which is to invest most or all of the loan proceeds until needed for college costs. To the extent the loan proceeds are traced to investments, the interest is deductible.

Investment interest may be limited on an annual basis, as it is only allowed to offset investment income. But if there is unused interest for any year, it does carry to the next year and should eventually be allowed.

How your plan actually plays out is based on what you do with loan proceeds and when you do it. But let me give a general story about what should happen based on what you have said so far.

First, interest on $100,000 of principal should be allowed as home equity debt interest. Because it does not matter what the proceeds are used for, there is no need to “trace” $100,000 of the loan proceeds.

Then, if $50,000 is left in an investment account, then interest on that amount should be allowed as investment interest. If you spend $30,000 of the loan proceeds, so you still have $120,000 invested, you continue to report interest on $50,000 as investment interest because the $30,000 can be deemed to come from the home equity proceeds.

Now let’s just say that by 2016 the loan balance is $130,000, you used $30,000 for a car and $30,000 for college. You still deduct interest on $100,000 as home equity, and since you still have $90,000 invested, the balance of the interest is investment interest.

Q: My 26-year-old son is now living with me. Is he too old to claim as a dependent for 2012?

A: No. There are now two ways to qualify as a dependent – as a qualifying child or as a qualifying relative. A qualifying child must be under age 24.

To be a qualifying relative, your child can be over age 23, but he must earn less than the dollar amount of the exemption for the year ($3,800 in 2012).

You must provide more than one-half the support of a qualifying relative. A qualifying child may be a dependent provided they do not provide more than one-half their support (that is, you need not support a qualifying child).

Because your son is over 23, he can be a dependent only as a qualifying relative. You need to provide more than half of his support and his gross income cannot exceed $3,800 in 2012.

James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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