Two Kinds
of Debt
Under the current tax system, there are
two different kinds if debt. Money you borrow to buy, build or
substantially improve your residence is called "acquisition
indebtedness." Money you borrow against the equity in your home, or
money you take out when you refinance your home for any reason except home
improvement, is called "equity indebtedness."
When you borrowed the money is also
important. Home loans taken out before October 14, 1987, is exempted from
the new rules. You may fully deduct interest paid on these loans,
regardless of their size or what you used them for. Any refinanced debt
you incurred before October 14, 1987, is rolled into your total
acquisition indebtedness. On loans made on or after October 14, 1987, you
can deduct mortgage interest paid on acquisition indebtedness up to a
total of 1.0 million. This means you could buy a home for $250,000, a
beach home for $200,000, and add a family room to your first house for
another $100,000, and still have $450,000 to spend on these homes for
further improvements before you reached your limit for interest
deductibility. The $1. 0 million is not cumulative. As you pay off a loan,
you would add that amount to your total purchasing or improving up to two
residences.
Your equity indebtedness limit is
$100,000. That means that you can borrow up to $100,000 of the equity in
your home and use it for whatever you want. This is a change from the
pre-1986 tax rule that limited your equity borrowing beyond the purchase
price to certain qualified expenses, such as home improvements, medical
and education expenses.
Refinancing
Your Mortgage
Interest rate have declined recently,
and many homeowners have taken advantage of this drop by refinancing their
mortgages. In the past, refinancing your mortgage has proved to be an
excellent opportunity both to lower your interest rate and monthly payment
and take equity out of your home.
When refinancing your mortgage, you
will probably pay 3 percent to 6 percent of the loan amount in closing
costs-for surveys, legal fees and paperwork fees. Many of these closing
costs are deductible, but not necessarily in the year that you refinance.
I f you are considering refinancing your mortgage under the current tax
rules, however, there are a couple of things to bear in mind. If you
refinanced before October 14,1987, for a longer term than was remaining on
the pre-October 14 loan, you may only de duct the interest paid on the
mortgage for the term that was remaining on the old loan. So if you
refinanced a loan with 15 years remaining for a 30-year loan with lower
payments, you can only deduct the mortgage interest paid on the new loan
for 15 years. The one exception is if you had a balloon mortgage payment
come due after October 13,1987 and you refinanced it to a loan of not more
than 30 years; you get the deductibility for the full term of the longer
loan. Any refinanced debt you incurred before October 14,1987, is rolled
into your total acquisition indebtedness.
In the past many homeowners have
refinanced mortgages on their appreciating properties to draw on their
equity to buy a new car or take a vacation. Under the new tax system,
homeowners will no longer have unlimited mortgage interest deductions when
drawing on equity. Any equity debt incurred is subject to a limit of the
amount of on equity. Any equity debt incurred is subject to a limit of the
amount of the existing debt plus $100,000. Say, for instance, that you
bought your house 10 years ago and have seen the property grow in value
from $70,000 to $230,000. If you refinance your mortgage (on which you now
owe $50,000), you may only deduct the interest paid on the total of your
acquisition indebtedness in the property ($50,000) plus $100,000. You will
be able to deduct the interest paid on $150,000.
Second
Mortgages
A second mortgage allows the homeowner
to cash in on some of the equity that has built up in the home over time.
Some lenders call a second mortgage a "junior lien." Getting a
second mortgage is very much like taking out your first mortgage (i.e. you
w ill be required to pay closing costs of 3 percent to 6 percent of the
loan value).
You may deduct the interest paid on
second mortgages made on or after October 13,1987, up to the $100,000
limit had already been reached when the first mortgage was taken out. The
amount of second mortgages made before that date is part of your
acquisition indebtedness total figure. This means that if you had $50,000
left on your first mortgage as of that date, and had taken out a $25,000
second mortgage on the property prior to October 14,1987, you would have
an acquisition indebtedness of $75,000.
Home
Equity Lines of Credit
While the 1986 tax reform called for
consumer interest deductibility to be phased out by 1991, only the
$100,000 cap now limits interest deductions on equity indebtedness. This
means that interest paid on home equity lines of credit - loans secure d
by your principal or second home - is still deductible.
Where the traditional second mortgage
gives the homeowner money in one lump sum the home equity line of credit
allows homeowners to use the equity in their home like a giant credit
card. The lender allows the homeowner to borrow at will against the equity
in the home, and charges interest only on the portion of the equity
borrowed against. Therefore, your interest deductions for a home equity
line of credit depend on whether you borrow against the equity during that
year.
Loan Type
Varies Interest Deduction
As we've said, the mortgage interest
tax deduction is one of the best financial reasons to buy a home. You may
be wondering, however, what total interest charges are like on the typical
home loan. In the chart, you can compare a 30-year fixed-rate loan with
15-year and bi-weekly mortgages for the same amount. As you can see, the
amount of interest you pay over the life of your loan depends on what kind
of mortgage you determine is best for you.
$75,000
MORTGAGE
30
Year 15 Year Bi-Weekly Fixed Rate Fixed Rate Mortgage At 10% at 10% at 10%
Monthly Payment $ 658 $ 806 $ 658 (329 X 2) Interest Cost First Year $
7,481 $ 7,398 $ 7,434 Fourth Year $ 7,336 $ 6,606 $ 7,061 Mortgage Balance
First Year $ 74,583 $ 72,726 $ 74,476 Fourth Year $ 73,052 $ 64,732 $
69,817 Interest Cost/Life $ 161,942 $ 70,062 $ 104,331 Difference from
30-year -$ 91,880 -$ 57,611
The Tax
Benefits of Selling Your Home
The new tax code does not tax the
profits from the sale of a home if the proceeds are used to buy another
house costing at least as much as the sales price of the old one. If you
or your spouse is at least 55 years old, you may be able to sell your home
and exclude the first $125,000 of gains from your taxable income without
reinvesting the money.
