If you are a small business owner looking for capital to start a business
or expand an existing one, you will quickly learn that most lenders will
require you to be personally liable on a secured loan.
A favorite source of funds for a small business owner looking for capital
to start a business or expand an existing one is a loan on their home.
Home loans usually provide a lower interest rate and are far easier to
obtain than a business loan, which almost always will require a business
owner to sign a personal guarantee and provide adequate security.
If planned carefully, using a home loan for business can provide a quick
source of capital. However, if not thought out correctly, it can lead
to unexpected tax results due to the complexity of the home mortgage interest
rules. There are four tax rules that cause the complication and must be
taken into consideration when considering your financing options:
1. Interest from loans secured by a taxpayer’s home (or second
home) must be deducted as home mortgage interest to the extent the loans
do not exceed specific debt limits for home mortgages, which are $1 million
for acquisition debt and up to $100,000 of equity debt. Thus,
a taxpayer cannot arbitrarily allocate a portion of the home mortgage
interest to another use such as the taxpayer’s business.
2. The interest on loans secured by the home in excess of the sum
of the acquisition debt and the equity debt can be traced to the use of
the funds using the general tracing rules. Thus, the
interest in “excess” of that allowed to be deducted as home
mortgage interest can be traced to the actual use of the money (for example,
the taxpayer’s business).
3. A taxpayer can make a tax election to treat any debt on the
taxpayer’s home “as not secured by the home”.
This election cannot be reversed without the IRS’s consent but can
be eliminated by terminating the loan. This election is dangerous in that
once it is made none of the interest can be deducted as home mortgage
interest. Although you will now be able to trace (allocate) the portion
related to your business, any part of the loan that is attributable to
the home is no longer deductible. Thus, this election generally works
best when used for second loans or lines of credit that are used 100%
for business use.
4. Equity debt interest secured by the home or second home is not
deductible for alternative minimum tax purposes. Thus, a taxpayer
receives no tax benefit for interest paid on an equity debt to the extent
the taxpayer is subject to the AMT. Business interest, on the other hand,
is deductible for AMT purposes.
So why do you care where the interest is deducted? First and foremost,
when interest is deducted as a business expense, it offsets your business
income for both regular tax and self-employment tax. Another reason is
that you may not have enough deductions to itemize so there is no tax
benefit gained from the home mortgage interest deduction. And there is
the issue of equity interest not being deductible for AMT purposes where
business interest is.
Examples
To better understand how these rules
play out, let’s apply them to some examples. Let’s assume
that you currently have a $200,000 mortgage on your home, all of which
is acquisition debt or refinanced acquisition debt. For this purpose,
the $200,000 acquisition debt is debt incurred to acquire the home and
any debt incurred to subsequently make substantial improvements on the
home. The current market value of your home is $500,000.
Scenario A
You need $150,000 to start
your business so you refinance your existing $200,000 mortgage for $350,000
and you do not exercise the unsecured election. During the year, you pay
$10,000 of interest on the loans. According to rule #1, you first must
allocate the interest to home mortgage interest to the extent allowable
as home mortgage interest and then the excess can be traced to your business.
Thus, $200,000 of the debt is attributable to refinanced acquisition debt
and the next $100,000 of the refinanced debt must be treated as home equity
debt. The remaining $50,000 of debt is excess debt and per rule #2 can
be traced to your business. Thus, only $1,429 of the $10,000 of interest
can be traced to your business. The remaining interest must be treated
as home mortgage interest and deducted as an itemized deduction, if you
can itemize.
Scenario B
Same as scenario “A”
except you elect to treat the loan as unsecured (Rule #3). Since rule
#1 only allows a taxpayer to deduct interest as home mortgage interest
on debts that are secured by the home, the interest on the $200,000 of
the acquisition portion of the refinanced debt is no longer deductible
for any purpose since it is traceable to, but not secured by, the home.
However, since the loan is unsecured none of the amount in excess of the
$200,000 needs to be treated as equity debt and instead $4,286 ($10,000
x 150/350) of interest from the remaining $150,000 of that debt can be
traced to your business. So, although you increased the amount that is
deductible as business interest, you lost the amount that could have been
deducted as acquisition debt interest.
Scenario C
Instead of refinancing the
first trust deed, you leave it alone and obtain a 2nd TD (or a line of
credit) for $150,000. You make the unsecured election for just the 2nd
TD. Since the original loan is still secured by the home, the interest
on that loan is still allowed and deducted as an itemized deduction as
usual. And, since the 2nd TD is treated as unsecured, the interest on
that debt can be traced to and deducted on your business. So even though
you pay a slightly higher interest rate on a 2nd TD, you will still be
able to deduct all of the interest.
These rules can be confusing and require some in-depth planning to ensure
you maximize the benefits of the interest deductions based on your overall
business needs, existing loan mix and personal tax structure. Please call
this office for assistance prior to any refinance, whether it is personal-
or business-related, to make sure you get the most from your interest
deductions while avoiding pitfalls.
