Making Home-Equity Loans Deductible The rules are simpler in '88, but now there is a write-off ceiling.
By Richard Eisenberg

(MONEY Magazine) – Like legions of other homeowners, Eugene and Christina Genovese found the temptation of a home-equity credit line irresistible. The Genoveses bought their five-bedroom colonial-style house in Holmdel, N.J. in 1985 for $285,000. A sizzling local real estate market has elevated its value to about $525,000. So in December Eugene, 37, a CBS technician and freelance broadcast consultant, and Christina, 28, a homemaker, turned their expanding equity into a ready source of cash. They were approved by a local bank for a $50,000 credit line. ''I view this money as insurance,'' says Eugene. ''We're not in favor of more debt, but it's nice to know money is there if opportunities arise.'' If they do, they probably will be in real estate. Gains from the Genoveses' old house in Queens, N.Y. helped them to come up with the $185,000 down payment on the Holmdel house. In the near future Eugene has plans to sell a residential and office rental property in Queens; he is hoping for another six-figure price. In addition, the Genoveses say they might use some home- equity cash for landscaping, furniture and a swimming pool for their son Anthony, 5, and daughter Dana, 11 months. But the Genoveses are baffled by the new tax rules that apply to home-equity loans. ''I have a lot of questions,'' says Eugene. ''Is it in our best interest to use the credit line? Will our eligibility for interest deductions be harmed if we make investments with the money? Does it all have to go toward improvements to get the maximum tax benefits?''

ADVICE AND A WARNING Jo Irene Dochych, a self-employed certified public accountant in Hazlet, N.J. who reviewed the Genoveses' taxes for Money, says the answers to Eugene's questions are simple: all the interest the couple pay on the $50,000 loan will be fully tax deductible, no matter what they spend the money on. (Interest on consumer debts such as credit-card and personal bank loans is only 40% deductible in 1988.)

But Dochych cautions that tax write-offs should be the least of the Genoveses' concerns about the line of credit. She warns the couple against borrowing the full $50,000 in 1988 because their $65,000 annual income cannot support so much additional debt. Dochych says if they took the entire $50,000 in 1988, it would add $8,400 a year to the family's debt costs, on top of the $12,000 a year they pay on the $100,000 mortgage on the Holmdel house. That would push the Genoveses' housing expenses to almost 38% of gross income, way past the 25% that is generally considered safe. Borrowers like the Genoveses get a roomy tax shelter under the home-equity loan rules that Congress first enacted in 1986 and then amended a year later. Starting on Oct. 14, 1987, you can deduct interest on a home-equity loan of up to $100,000 ($50,000 if you are married and filing separately) against a residence or a second house, regardless of how the money is used. The loan cannot exceed the house's fair market value. For taxpayers who borrow more than $100,000 against the equity in their homes from now on, the size of the interest write-off depends on the way the excess cash is spent. Any amount of it that goes into the taxpayer's business is fully deductible, but money exceeding $100,000 used for investments can be deducted only up to the amount of his or her investment income plus $4,000. If the excess cash is used for any other purpose, the money is then regarded as a consumer loan, and only 40% of the interest can be deducted in 1988. Those are the new, supposedly simplified rules. For 1987 tax returns, you must stick with the more restrictive law that Congress enacted in 1986. It lets you fully deduct interest on a home-equity loan only if the amount you borrow plus the balance of your first mortgage does not exceed the lesser of either: a) your house's fair market value, or b) the purchase price of the house, including buying expenses such as attorney's and title-search fees, plus the cost of improvements. For example, if the Genoveses had withdrawn all of their line of credit last year, they could have deducted the interest fully in 1987. Reason: the roughly $150,000 they would have owed on their first mortgage and their home-equity loan would have been less than the price of their house, including fees connected with the purchase, plus what they spent on improvements such as a new deck and wood trim throughout the house -- a total of about $290,000. Anyone who took out a home-equity loan in 1987 exceeding tax reform's limits faces tedious paperwork. It is explained in the Internal Revenue Service's new two-page Home Mortgage Interest form, No. 8598. For a quicker way to calculate your mortgage interest deduction, see the Chalk Talk on page 86. In addition to paperwork that might make them wish they had rented, big borrowers may not be able to deduct all of the interest on their 1987 home- equity loans. The write-off for home-equity interest exceeding the 1987 limits hinges on how you spent the loan. Your interest is fully deductible if the money went for educational or medical expenses for yourself, your spouse or your dependents. The same is true if you spent the money for your trade or business. If, on the other hand, you invested the borrowed money, you can write off the interest only up to the amount of your 1987 investment income plus $6,500. Other uses of home-equity money above the limits set by Congress in 1986 are regarded as consumer debt and are only 65% deductible on a 1987 return.

WHO COMES OUT AHEAD Some borrowers will fare better with the old rules, while others will enjoy a bigger tax break under the $100,000 cap that applies now and in future years. Julian Block, a tax specialist at Prentice-Hall, the publishing house, says that home-owners may benefit from the rule for loans made after Oct. 13, 1987, if they bought their houses years ago when real estate prices were low. But parents with several children planning to attend expensive colleges could turn out to be losers under the new cap, since they will not be able to deduct interest on home-equity loans above $100,000. The IRS might disallow deductions for some people who failed to deposit their borrowed money in its own checking account. ''If you kept your home- equity proceeds in an account mixed in with your paychecks and stock dividends, IRS auditors might reject the write-off saying they don't know how you spent the money,'' notes Andrew Rothenberg, a New York City senior tax manager at the accounting firm Touche Ross. Paperwork will turn out to be far less burdensome for most borrowers in 1988. If your loan is for less than $100,000, you need not set up a special bank account for it or even keep records showing where the money went.

BOX: Eugene and Christina Genovese

Home: Holmdel, N.J. Ages: 37 and 28 Occupations: broadcast technician-consultant and homemaker 1987 gross income: $65,000 Tax bracket: 28% Tax question: Will the interest on their home-equity loan be tax deductible for 1988? Advice: Yes, because they will be borrowing less than the new $100,000 limitation.