This week, Gail addresses two parallel topics: Taking money OUT of a home... and putting money INTO a home.
I bought my condo a few years ago for $100,000 and it is currently valued at $150,000. My original down payment on this property was $10,000. Then I installed some new fixtures in the bathroom and kitchen, which amounted to roughly $20,000.
I just got approved for a $30,000 home equity credit line at 6.75%. I plan to use half of it to consolidate and eventually eliminate my higher-interest credit card debt and the other half to make some additional improvements to my condo. I've been told that because I am not using the entire amount to cover home improvements, none of the interest will be tax-deductible. Is this true? I thought a home equity loan was entirely deductible. If only part of the interest is deductible, how do I determine the amount?
Dear Willi —
You and thousands of other home-owning Americans have discovered one of the few investments that went up last year: their homes. And thanks to seven cuts in interest rates so far this year by the Federal Reserve, mortgage interest rates are near rock-bottom.
I'll bet the rate you're getting on your home equity loan is less than half (and in some cases one third) the rate you're paying on your credit cards. By borrowing against the increased value of your home, you're able to re-finance a big chunk of your debt at a much lower interest rate. Smart move!
However, you are making a common mistake in thinking that interest paid on home equity loans is always tax deductible. Dave Binder, a CPA with the firm Pfeiffer and Binder in Mars, Pa., says you can only deduct the interest to the extent you have "basis" in your home. This has nothing to do with the current value of your home — the appraisal most banks do to determine this affects how much they are willing to lend you but is not a consideration with regard to the deductibility of interest.
"Basis" means your "cost basis," or how much money you've actually got invested in your condo. To figure this out, Binder says start with what you paid for the condo. Then add the cost of any improvements you've made. In your case, this amounts to $120,000 — the purchase price plus the kitchen and bathroom improvements.
Subtract the balance on your mortgage from this amount. For the sake of argument, let's assume you've pared the original loan of $90,000 down to $85,000.
You cost basis in your condo is: $120,000 - 85,000 = $35,000.
This means if you borrow up to $35,000, all of the interest you incur will be tax deductible no matter what you spend the money on. However, if you borrow more than that, the additional interest is not deductible — unless you use this money to pay for home improvements. That's because doing so would increase your "cost basis" in your condo.
I love to be able to deliver this kind of good news: In your case, the interest on your $30,000 home equity loan is entirely tax-deductible!
P.S. Regardless what your cost basis is, the biggest deductible home equity loan you can take is $100,000. That's not to say the bank won't loan you more. That's just the maximum loan the government will allow an interest deduction on.
My wife and I are considering withdrawing some of our IRA in order to build a house. We are both 47 and are tired of renting. Any thoughts?
Dear Paul —
I don't want to come across as harsh, but my first thought is: Why haven't the two of you been able to save the money outside your IRAs by this point in life? Home ownership definitely offers some special advantages, but I really hate the idea of you raiding your retirement nest egg to come up with the down payment.
My second question is: What kind of IRAs do the two of you have? Thanks to tax legislation passed in 1997, you can withdraw up to $10,000 from an IRA to purchase a "first-time" home and not have to pay the typical 10% penalty for taking money out prior to age 59 1/2. But keep in mind this is a once-in-a-lifetime privilege.
Furthermore, while contributions to a Roth IRA can be withdrawn at any time, penalty-free, you could run into a problem if you take out more than that. For instance, if you dip into the earnings on your account before it's been open at least 5 years, then you will owe taxes on that amount.
Which brings up my third question: What is your tax bracket? While you can access your money penalty-free, if it is coming from a traditional, tax-deductible IRA, you still owe income tax on the entire amount withdrawn. This is going to reduce the amount available toward a down payment. For instance, if you withdraw $10,000 and are in the 27 1/2% tax bracket, you will end up with $7,250.
Before you raid your retirement stash, do some homework to see if you might be able to find a lender willing to accept a smaller down payment, say 5% instead of the typical 20%. Then see if you can come up with the cash you need from another source.
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.