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Turn personal interest into tax deductions

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Are you paying interest on a personal loan or credit card charges? Generally, you can’t derive any tax benefits from the interest on these loans. It’s considered a personal expense and is therefore nondeductible.

Strategy: When appropriate, consolidate debts under a home equity loan. As a result, the interest you pay on the loan may be deductible within relatively generous limits.

Of course, a home equity loan or line of credit (in states where it is allowed) is often used for home improvements, but it can also be used to pay off other liabilities that generate nondeductible interest.

Here’s the whole story: Generally, you can deduct “qualified residence interest” (commonly called mortgage interest) paid during the year. To qualify, you must be legally obligated to pay the mortgage and it must be secured by a qualified home. The home can be your principal residence or one other home like a vacation home.

The deduction limit depends on whether the debt is an acquisition debt or a home equity debt.

  • Acquisition debt: The debt is incurred to buy, build or improve a qualified home. The mortgage interest paid on up to $1 million of acquisition debt is fully deductible.
  • Home equity debt: Any other qualified debt, such as a home equity loan or line of credit, is treated as home equity debt. The mortgage interest paid on up to $100,000 of home equity debt is fully deductible. But home equity debt can’t exceed the fair market value of the home on the last day of the year reduced by the outstanding acquisition debt.

The main tax attraction of home equity debt is it doesn’t matter how you use the loan proceeds. Thus, you can use it to eliminate other debts with higher interest rates.

Tip: Because you’re putting up your home as security, use this technique judiciously. Also, if you are subject to the AMT, you can only deduct interest on home equity debt to the extent you used the loan proceeds for improvements to your first and/or second home.

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