One of the many changes made way back in 1986 by the Tax Reform Act of 1986 (TRA 86) was to severely limit the amount of interest that can be deducted on a tax return. Taxpayers have generally picked up that personal interest can no longer be deducted, but there are many other overlooked limits, particularly concerning the deductibility of home mortgage interest. Although it goes against common wisdom, including that of some real estate agents and mortgage brokers, you can’t always deduct your mortgage interest.

While I will review the home mortgage interest rules in detail below, it is important to put mortgage interest in the context of the major change in interest deductibility made by TRA ’86. Instead of determining the deductibility of interest by where the loan came from, interest deductibility (or nondeductibility) is now determined by what the loan is used for (with a small exception for certain home mortgages). This principle is known as the “tracing rules.” We no longer look at where we got the money, but at what we spent it on.

As an example: If you take out the equity of a rental house you own, you can’t automatically deduct the interest on that rental’s Schedule E. If you use the loan to replace the roof and renovate the rental property, then indeed you can deduct the interest on that rental’s Schedule E. If you use it as down payment on another rental property, you may deduct it on that new rental’s Schedule E. If you use it for a cruise around the world, it’s personal interest and not deductible at all. If you invest it in securities, it is potentially deductible under the rules for investment interest. If you are self-employed and use it for your business, it would be deducted on your business Schedule C. And so on. If you use the proceeds for several different purposes, you have to allocate the interest among those several uses, and deduct it (or not) according to the rules for each use.

As if this isn’t complicated enough, Congress carved out exceptions for home mortgages. According to the tracing rules, home mortgages used to purchase personal residences would be personal interest and therefore nondeductible. So Congress made two exceptions to the tracing rules: “home acquisition indebtedness” and “home equity indebtedness.”

“Home acquisition indebtedness” is, as the name implies, the loan used to acquire or construct your house. It also includes any loans you may have had before 13 October 1987 (when this law went into effect) and any loans you may make after purchase to substantially improve your residence. “Home acquisition” debt may be used for your principal residence and any one other residence (your choice, if you have more than one other personal residence). However, it is limited to $1,000,000 total, and it must be “secured” by the house involved and the deed recorded within a “commercially reasonable” time. In essence, if you do not pay the loan, the lender can take the house.

Notice that home acquisition debt can never be greater than the cost of the house(s) plus improvements. Notice also that it goes down as you pay on the loans over time. And be aware that if you refinance, your refinanced loan is home acquisition debt only up to the remaining balance of the original home acquisition debt before the refinance.

In a sense, home acquisition debt follows the tracing rules, but allows an interest deduction (within limits) for this one type of personal expense. The second type of home-related debt, “home equity indebtedness,” ignores the tracing rules altogether. Essentially, it is any debt secured by your principal and/or second residence that isn’t home acquisition debt. And the deductibility rule is simple: the loan can’t be greater than $100,000 for the interest to be deductible. But that $100,000 may be used for any purpose at all, even that cruise around the world.

Again, a couple of things to notice. First, you don’t have to treat a loan (or part of a loan) secured by your house as either home acquisition debt or home equity debt if you don’t want to. That can work to your advantage if it is deductible under the tracing rules for something else—for example, if the proceeds are used for investments or in your business. Second, you don’t have to have two or more separate loans for acquisition debt and equity debt or any other purpose. One loan may be apportioned among all uses, based on the principal amount of each use. Third, it doesn’t matter what your bank calls your loan. If you get a loan your bank calls a “home equity line of credit” and you use it to remodel your home, it is acquisition debt.

One more possible pitfall: for alternative minimum tax (AMT) calculations, the “qualified housing interest” deduction allowed in that tax system is in most cases equivalent only to “home acquisition” interest in the regular system. In other words, “home equity” debt interest is not deductible for AMT purposes.

Here are a few sometimes unnoticed consequences of these rules:

1. Because of the tracing rules, your “margin interest” from your brokerage account is not necessarily investment interest. It is investment interest only if it is actually used for investments. If, for example, you use it to pay your personal income taxes, it is personal interest and not deductible.

2. If Mom and Dad lend their grown child money for the down payment on the child’s house, the interest on that loan is not deductible as home acquisition interest for the child unless the loan is secured by the house and the deed is actually recorded “within a commercially reasonable” time.

3. If you pay all cash for your house, you have no acquisition debt at all. If you later want to put a mortgage on the house, you are limited to a home equity debt of $100,000 for deductible home mortgage interest. Of course you can have as large a loan as your bank will give you. But only the interest on the first $100,000 will be deductible as home mortgage (i.e., “home equity”) interest. Only if you use the proceeds to remodel that house can it become “home acquisition” debt

4. If you refinance your residence and take out your equity, you are limited to $100,000 in debt over and above what remains of your home acquisition debt. Interest on any debt greater than the allowed $100,000 over acquisition debt is nondeductible as home mortgage interest. If the tracing rules allow it, you may deduct the excess interest as some other type of interest, but it is not deductible home mortgage interest.

5. If you refinance a rental property and take out its equity, you must use the tracing rules to determine whether or not any interest is deductible. For example, if you use the loan proceeds to buy a new personal residence, the interest is not deductible by the tracing rules (it is used for a personal expense), and it is not deductible by the residence rules (it is not secured by the residence). Therefore the interest is not deductible at all.

To sum up, the equity in your house is not an inexhaustible source of deductible loan interest. Consult your tax advisor before you leap.

© 2006, Irene Lawrence, EA. This article is not intended to provide advice or service on any individual tax issue and cannot be relied on for that purpose. It is provided with the understanding that Irene Lawrence, EA, is not engaged in rendering legal, accounting, or other professional advice or service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.