ALBUQUERQUE, N.M. — Q: I have carried credit card balances of up to $30,000 over the past year and I don’t see any short-term solution to this issue. I have a house with a mortgage of about $127,000 that is worth more than $250,000. I now think that the smartest thing to do is to get a home equity loan and to use the money to pay off the credit cards. The interest rate will be lower, and I believe that I will be able to deduct the interest on the home equity loan, and that I currently cannot deduct the credit card interest. Can you confirm this for me?
A: The deductibility of interest depends on how it is classified. Personal interest is not deductible. Interest classified as business, investment, education, passive or residence may be deductible in whole or in part.
Interest is classified based on tracing the use of funds. So whether the credit card interest is deductible is based on what the borrowed funds were used for. Charges for business expenses, as one example, would create deductible interest.
However, if you use your credit card for the types of purchases that most people do, you are probably correct in concluding that none of the interest is tax deductible.
There is one exception to the rule that tracing loan proceeds determines the classification of interest. If the loan is secured by a residence, and that security interest is perfected under local law, interest can be deductible without regard to the use of the funds. However, this classification, called home equity indebtedness, has a limit of $100,000 of principal that creates deductible interest.
Loans secured by a residence and used for acquisition, construction or improvement of the residence allow interest to be deducted on principal up to $1 million.
The use of a home equity loan to pay off your credit cards would fall within the home equity classification provided the loan is secured by the residence. The home equity lender would insist on this and would ensure that the security interest was perfected under local law. So your plan to replace high-interest, nondeductible interest with a lower and tax-deductible rate should work subject to two caveats.
First, you need to itemize deductions to get any tax benefit from the interest. Second, the interest will not be deductible for purposes of the alternative minimum tax (AMT).
The AMT, which functions like a parallel tax system, allows home-equity debt interest only if it is used for acquisition, construction or improvement of a residence. So you will lose the tax benefit for any year that the AMT applies.
Q: I opened a new business in March. Starting last September I used my savings to investigate the industry and to pay for travel, licenses and other investigation costs. The business is operated as a proprietorship. My question is whether I can reimburse myself for the costs incurred before the business started. Would this be taxable to me?
A: If the business is a proprietorship then you are taxed on any net income that it generates, and you will file a schedule C with your personal tax return. Any money in the business is yours, and you can withdraw funds with no tax effect. It doesn’t matter whether you call it a reimbursement or not.
The costs that you describe fall into a category that the tax law calls “start-up” costs. These are costs that would be deductible for someone operating a business, but which cannot be immediately deducted because they were incurred before the business started.
These start-up costs become deductible beginning with the month that the business starts. It used to be that the costs had to be amortized over a period set by law. Congress changed the law to allow a deduction for up to $5,000 of start-up costs. Any costs incurred in excess of $5,000 must be amortized over 180 months.
No deduction is allowed until the month that the business starts. So you should not have claimed any business deduction in 2010.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.