Taxes on home equity

I have some questions regarding taxes and home equity lines of credit, or HELOCs. I owned a home with a mortgage balance of $360,000. I used all of the funds from a $90,000 HELOC to put a down payment on a second home, renting out the first. I bought a second home with a mortgage balance of $287,000, and took a $57,000 HELOC out on the second home (now my primary residence). I used $30,000 of this HELOC to make repairs and the rest to consolidate some debt.

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How much of the interest paid on each of these four loans (two mortgages, two HELOCs) is deductible? (i.e.: What are the deduction thresholds given this situation?)

Does it matter what the money used from a HELOC is spent on? Do home improvements count as a deduction, but not other kinds of spending? How does the IRS track this?
-- Brian

Dear Brian,
First off, the IRS doesn't track this, you do. The general rule is that you can deduct as home mortgage interest the interest paid on up to $1 million in mortgages used to acquire or substantially improve a principal residence and a second home that you use personally. You can also deduct the interest on up to $100,000 of home equity debt that is used for any purpose.

Because the $90,000 HELOC is on a rental property, it does not qualify as home mortgage interest unless you use the home as a vacation home during the year. Furthermore, because the $90,000 loan was used for personal purposes, it is not deductible against rental income. The $360,000 mortgage would be deductible against the rental property income.

The $287,000 debt was used to acquire your home, so that is home mortgage interest, deductible within the $1 million ceiling. The $57,000 HELOC is home equity debt within the $100,000 limit. In fact, the $30,000 used to make repairs can be considered part of the acquisition debt, so that only $27,000 of this HELOC fits within the $100,000 ceiling. Because you have $73,000 available under the $100,000 ceiling, you might want to consider refinancing the HELOC that is not deductible on the rental property.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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