“What happens to interest deduction on personal residence home equity loan proceeds which are used to buy a new personal residence?”============== Financing a second home is often tough because of the strict lending standards that lenders use. One option that is sometimes overlooked is using a home-equity loan to buy the second house. One of the advantages of doing this is that you can get a break from the IRS for this process. The amount of interest that you pay on your home-equity loan is tax deductible. This allows you to lower your taxable income by the amount of the mortgage interest. If you had to pay points on the loan, you can also deduct this because it is a form of prepaid interest. Since the loan is on your first house, you can take the deduction regardless of how you use your second home. If you had secured by the second house, you would not be able to deduct the interest if you rented the house out. When you take out a home equity loan, the debt may be classified as either mortgage debt or home equity debt. If you use your home equity loan to improve /buy your home, you count the debt as mortgage debt. If you use the home equity loan for any other purposes, such as buying a new car or taking a family trip, the loan counts as home equity debt.The difference between mortgage debt and home equity debt matters because mortgage debt has a much higher limit for tax deductions. For mortgage debt, you can deduct the interest on up to $1 million. For home equity debt, the limit is much lower; you can deduct the interest on up to only $100K. For example, if you have $400K of mortgage debt, you could deduct all the interest, but if you have $400K of home equity debt, you could deduct only 25 percent of the interest. To claim the interest you pay on your home equity loan, regardless of whether the debt constitutes mortgage debt or home equity debt, you must itemize your deductions. When you itemize, you relinquish the standard deduction. If you do not itemize, you cannot deduct any of the interest on home equity debt. You itemize your deductions on Schedule A and file your taxes using Form 1040.
NOTE: By using this technique to purchase a house, you are essentially putting your primary residence at risk. If you cannot afford to make the home-equity loan payment, your primary residence could be foreclosed upon by the home-equity lender. On the other hand, if you had enough equity, you now own the second house without any loans or liens against it. Even if you do not pay the home-equity loan, the lender cannot take the second house from you. This requires you to risk your primary house, but the risk at least gives you something you can keep.