Cash Out Refinance For Your Home Is 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.
Do not worry you are not alone. You see we all believe that the interest you pay for your home (mortgage and a HELOC interest) is tax deductible. I found out the hard way that this is not really the case.
When you refinance on your home and use the money for any reason other than home improvement, the IRS limits your deduction for interest. In some cases you won’t be able to claim the deduction at all.
Here is how it works. The IRS starts by giving you a tax deduction for mortgage interest. There is a fancy name for this called the home equity indebtedness deduction.
All this simply means is that:
If you are married and file a joint return you are generally allowed to claim a deduction interest up to $100,000 of the funds you borrowed. If you file separate tax returns the limit is $50,000. I am only referring to one aspect of the deductions here which relates to refinancing or borrowing extra from your mortgage. There are other deductions and incentives so please consult your advisor.
Now that you understand the deduction here’s how they take it away from you.
Let us look at the following example to see how this works.
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.
You may be in for a surprise. If you previously claimed a deduction or thought of claiming a deduction this year, the IRS may limit your interest deduction lowering your refund.
You need to do a second quick calculation to find out the difference between the market value of your home and the costs plus improvements. In this example your market value is $320,000 and the cost is $300,000 so the difference is $20,000. This means is that even though you are allowed to claim up to $100,000 the IRS limits this and tells you that you can only claim interest on $20,000. So if you borrowed $30,000 and used this for personal use, the tax deduction for interest can only be claimed on $20,000. The interest you paid on the other $10,000 is disallowed.
Now if the market value of your home has decreased below the cost of your home, you cannot claim interest on any of the $30,000 you borrowed. I have seen hundreds of clients caught up in this potential tax trap and most of them have their taxes completed by their tax accountants. So if you home is worth $290,000 today and the original cost is $300,000, the entire interest you paid on the $30,000 you borrowed cannot be claimed for tax purposes.
A quick test to see if you are able to claim the deduction for mortgage interest.
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.