How Does A Cash Out Refinance Could Lead You In A Tax Trap
Have you ever refinanced your home, used the proceeds for personal use, and then claimed a tax deduction for the interest? I have some bad news. The IRS limits the amount you can claim as an interest deduction for tax purposes.
Are you confused by what this means to you.
It is not your fault. You are not alone. We are told that HELOC interest is deductible for tax purposes but sometimes, especially in this economy, this may not be the case, and you could land up in serious trouble with the IRS.
If you borrow money from your HELOC and use this to spend on personal items other than home improvement, you will not be allowed to claim a deduction on the mortgage interest for tax purposes.
The IRS does give you some tax benefit and call this the home equity indebtedness deduction.
The home equity indebtedness means:
One of the deductions that the IRS gives you as a homeowner is to claim a mortgage interest deduction of up to $100,000 if you file a joint return. If you file a single or separate return the deduction is limited to $50,000. To make sure that we are specific, I am referring to one aspect of the deduction only and that is when you refinance or borrow more from your mortgage.
Now that you understand the deduction here’s how they take it away from you.
Let us see how this works through the example below
Let us make an assumption that you owe $260,000 on your mortgage and that you bought your home for $300,000.
You decide to refinance and take cash out for $30,000. You worked hard and though it would be the ideal time to cash out. Can you claim an interest deduction on the entire $30,000? Let’s assume the market value on your home the day you decided to take the cash out refinance is $320,000.
There is some bad news to this. The IRS does not allow you to deduct the entire interest on the $30,000.
The best way to figure out what you can deduct is to do a simple calculation. According to the IRS you need to take the value of your home ($320,000) and from this you deduct the cost of your home ($300,000). The difference of ($20,000) is what you are able to claim as an interest deduction. You thought you may claim the entire $30,000 but as you can see the IRS limits this.
Now here is some bad news especially in this economy where home prices have fallen really steeply. If the value of your home is less than what you paid for it and you borrowed money from your HELOC for personal use, the IRS prevents you from claiming a tax deduction for the mortgage interest. Let us say your home is worth $300,000. It is value at $285,000 today. You borrowed $30,000 from your HELOC for personal use. The interest paid on the $30,000 is not deductible for tax purposes. If you have claimed this deduction in the past or plan to claim this in the current year, please do not. You could end up with penalties and extra fines.
How do you know if you are caught up in this tax trap?
Go to the url or the unique links below and gain access to a quick and easy checklist. In this document, we have given you suitable points to consider preventing you from making unnecessary mistakes when filling in your tax return.
If you are filling out your tax returns this year, and you have used funds from your HELOC for personal use, I strongly suggest that you first contact your tax accountant to figure out whether the interest is tax deductible. This is the best move right now, and could prevent you from paying extra taxes and penalties later on.
Please note that this article is for informational purposes only. No liability is assumed with the information presented above.
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