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Deduct home-equity loan interest as business interest

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Say you took out a home-equity loan last year and used the cash to pump up your pass-through business, such as an S corporation, partnership or limited liability corporation (LLC).

You’re generally entitled to deduct the interest paid on the first $100,000 of that home-equity loan as mortgage interest (as an itemized deduction on your Schedule A).

Our advice: Don’t take that normal route. Instead, “disclaim” the interest deduction available on Schedule A and claim the interest on Schedule C, E or F. In other words, you should treat the interest as business interest rather than mortgage interest for tax purposes.

Can it be done? Absolutely. The IRS has given its official approval in temporary regulations. You won’t have any problems as long as the loan proceeds are pumped into a business in which you “materially participate.” For most small business owners, that’s a breeze.

Why deduct home-equity interest on Schedule C, E or F, rather than Schedule A? Here are four advantages:

1. Your business-interest deduction is exempt from the usual phaseout of itemized deductions for high-income taxpayers.

2. The interest deduction reduces your adjusted gross income (AGI) because it’s claimed “above the line.” In effect, that reduces the negative impact of other unfavorable phaseout rules for various other tax breaks on your individual return.

3. The business-interest deduction generally reduces the amount of self-employment tax you must pay.

4. Your interest deduction won’t be completely or partially wiped out if you’re subject to the individual AMT.

Logistics: Make your disclaimer by attaching a statement to your 2005 Form 1040. The statement should say, “Taxpayer elects to treat the following debt as a debt that is not secured by a qualified personal residence.” List the loan amount and the lender’s name. (IRS Temp. Reg. 1.163- 10T(o)(5))

Can you still claim other mortgage interest deductions? Yes. In addition to interest on a mortgage taken out to acquire a personal residence (i.e., your regular monthly mortgage payments), you can generally deduct the interest paid on the first $100,000 of home-equity debt above and beyond the amount borrowed under your first mortgage.

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