Tax deductions vary for home-equity loans

Many borrowers don't realize they might not be able to deduct all of the interest they pay on home equity loans.

BY SUE McALLISTER
Knight Ridder News Service

Low mortgage interest rates made 2004 another big year for refinancing. And home-equity borrowing in the United States reached a record-high level last year, according to a recent study.

Americans took out $431.3 billion of home equity loans and lines of credit, according to SMR Research, a market research firm in New Jersey, 35 percent more than in 2003.

Yet many borrowers don't realize they might not be able to deduct all of the interest they pay on home equity loans. That would depend on how much they borrowed and what they used the money for. Taxpayers subject to the Alternative Minimum Tax face stricter limitations on what they can deduct.

First, it's important to know that in ''tax-speak,'' there are two kinds of mortgage debt: home acquisition debt and home equity debt.

Acquisition debt is a mortgage or mortgages you take out ''to buy, build or substantially improve'' your main or second home. In general, you may deduct the interest you pay on up to $1 million in home acquisition debt.

So let's say you took out a home equity loan and you used it to remodel your kitchen for $40,000. For tax purposes, that amount is considered part of your ''acquisition'' debt because it was used to improve the home. You can deduct the interest on that debt, as long as your total acquisition debt is $1 million or less.

From the IRS's standpoint, home equity debt is different. It is money you borrowed from your equity and used for purposes other than buying, building or improving your home. Only interest paid on $100,000 of equity debt is deductible as mortgage interest.

If you used a home equity loan to pay your child's college tuition, for example, you can deduct only the interest you paid on the first $100,000.

For more information, refer to IRS Publication 936, ''Home Mortgage Interest Deduction,'' or consult a tax advisor.