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Using home equity for startup

Q: My wife and I own our home free and clear. The house is worth about $400,000. My wife wants to start a business and she will need some capital for leasing an office, furniture, startup wages, advertising, and some computer equipment. We think that $60,000 will do for startup costs. Rather than trying to borrow from a bank, which I think would require a lot of paperwork related to the business, we are thinking about borrowing against our house. Will we be able to deduct the interest on that type of a loan?

A: Yes, you can deduct the interest, but you have a choice to make about reporting the interest.

The tax law has different classifications of interest, some which are not deductible (e.g., personal), some which are deductible (e.g., business), and some which may be deductible, but only in years that you have qualifying income to offset (e.g., passive or investment).

Even if deductible, the deduction may be claimed on the first page of the Form 1040 without regard to whether you itemize deductions, or may be reported as an itemized deduction on Schedule A.

Interest expense is usually classified by “tracing” the use of the loan funds. That is, if the loan funds are used for a personal expense, the interest is personal, and so on.

The one exception to the tracing rules is qualified residence interest. This is generally interest paid on a loan used to acquire, construct, or improve your principal residence or one other residence.

Qualified residence interest also includes “home equity debt,” which is debt not used to acquire, construct, or improve a residence, but which is secured by a residence. Interest on debt of as much as $100,000 can be deducted under this classification.

Any interest paid on a loan classified as qualified residence debt is deductible as residence interest without regard to how the funds are used. That is, the normal tracing rules do not apply to qualified residence debt.

Your proposed loan qualifies as home equity debt, and all interest would be classified as residence interest. This is deductible on Schedule A as an itemized deduction.

There is a special election that allows you to ignore the classification of the debt as qualified residence debt, which would allow the normal tracing rules to apply. You might want to make this election.

If you use the loan proceeds to fund your wife’s business, the interest would be classified as business interest under the tracing rules. It would be fully deductible against her business income and would end up as a deduction even if you do not itemize.

Taxpayers either claim itemized deductions or use the “standard deduction,” whichever is greater. The 2014 standard deduction for a married filing joint return is $12,400.

Without any other residence interest, it is possible that you may not itemize deductions or, even if you do, that some of the interest would be used to push you over the $12,400 threshold to itemize.

In either case, you may not get the full tax benefit from treating the interest on your proposed loan as qualified residence interest.

If you elect to ignore the qualified residence loan rules, the interest should be fully deductible and you will also leave a cushion of $100,000 of debt that could later be classified as home equity debt should you ever need to again borrow against the house.

To elect to ignore the qualified residence debt classification, you should just attach a statement to your 2014 tax return that references Treasury Regulation 1.163-10T(o)(5) and says that you elect to treat the debt as not secured by a qualified residence.

If you elect to treat the debt as not secured, it would not satisfy the qualified residence interest definition and would then be subject to the tracing rules. The election applies to the year it is made and all subsequent years.

You would typically be better off tracing the debt to the business expenditures and deducting the interest as business interest. Nonetheless, it is a good idea to evaluate the result of the two classifications before making the election on the 2014 return to make sure your situation is “typical.”

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