If you use a home equity line of credit for personal use, do you know you may be in trouble with the IRS if you plan to claim a deduction for mortgage interest?

Are you not entirely certain how you could end up paying penalties to the IRS.

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.

The home equity indebtedness means:

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.

The example below explains this in more detail

Let us assume at the time when you first acquired your home you paid $300,000. But now you only owe a balance of $260,000.

YOU took $30,000 from your HELOC and decided to use this for personal use. And you figured that since you borrowed the money from the HELOC the interest paid on the $30,000 is fully tax deductible. You also received some good news the day you borrowed this extra money. You were told that your home is valued at $320,000.

The IRS limits your deduction according to the following:

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 here is the biggest surprise of all. If you home is currently worth less than what you bought this for, you cannot claim interest on the borrowed money if you use the money for personal reasons. So for example if you bought the home for $300,000 and it is now fallen down in value in this market, and the value is $280,000, the IRS prevents you from deducting the interest you borrowed on the $30,000. Bad news, especially in this year when the home prices have fallen, you may not be able to claim a deduction for interest when you borrowed on the HELOC.

A quick test to see if you are able to claim the deduction for mortgage interest.

Please click on the links below and quickly access a list of points or a special check list. In this list, we have provided the steps preventing you from making a silly mistake when preparing your tax return.

I strongly recommend that you contact your tax accountant immediately if you have used your HELOC funds for personal use in the last year. This will ensure that you claim the right deductions and prevent yourself from being audited.

Please note that this article is for informational purposes only. No liability is assumed with the information presented above.