Equity-loan interest remains deductible

Q: I have a vacation home that was purchased for $225,000 using a mortgage of $210,000. It was later appraised for $262,000, and I took a home equity loan of $40,000 to consolidate other debts. Now the property is worth no more than $210,000 to $220,000, the original loan is $187,000 and the equity loan is about $38,000. So I am at about $225,000 for all loans and this exceeds the value of the house. Can I still deduct all the interest on the home equity loan? When I took the loan I was advised that to deduct the interest, the loan had to be secured, which the bank did, and that the total loans could not exceed the value of the house. Well they didn’t, but now they do. It seems I am a victim of the market and not a tax abuser, so it would seem unfair to deny me interest deductions just because the market fell. Do you know how this works?

In 1986 Congress changed the law to deny interest deductions for consumer debt. However, interest on residence debt for a principal residence and one other residence continued to be deductible.

As partial relief for consumer debt, a new category of interest was created for home equity debt, which was debt secured by a principal residence or a second residence. Interest was deductible up to the interest paid on $100,000 of principal. Also, home equity debt interest may not be allowed for alternative minimum tax.

Some clever banks decided that to entice consumer borrowings, they would allow people to borrow more than 100 percent of the value of their home using home equity debt. This would be the economic equivalent of unsecured consumer debt, but the borrower could deduct the interest.

There were two problems with these loans. First, consumer advocates argued that borrowers did not know they were placing their homes at risk. Second, Congress did not intend a loophole like this to permit continued deductions for consumer debt.

So, in 1987 a technical correction was added to say that interest would be disallowed on any principal that, with other loans secured by the residence, exceeded the fair market value of the residence.

The law simply says fair market value and does not say when that should be determined. But IRS regulations say that it is the fair market value “as of the date the debt is first secured.” This means that your interest will continue to be deductible.

Q: I have an adult son who graduated from college and was not able to find a decent-paying job so he is back living with us. My wife insists that we charge him rent, which I think is kind of silly because he can’t afford much. He pays us $200 per month. Now someone tells me I have to report that to IRS as rent income. Really? It’s almost nothing and I would rather just not charge him if I have to start adding to my taxes.

If you are receiving rent, then it would have to be reported on schedule E. You would be entitled to deduct certain expenses, but the below market rent would force you to use interest and property taxes first, and to only claim expenses up to income.

So you would report $2,400 per year as rent income and then move $2,400 of interest and taxes from your itemized deductions on schedule A to schedule E to zero out the rent income. In the end, you report $2,400 more income and probably get no real benefit from the expenses.

Rent is a payment for the use of property. So it would exist when you demand that he pay $200 per month for the privilege of occupying space in your home. I think you might be able to get to the same end result by charging him $200 per month for his share of the groceries.

If he is allowed to use the house for free but has to pay for groceries, you have no rental arrangement and no need to report rent income. Consider this option and make sure to get your wife’s approval for the story to tell your son.

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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