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Interest Paid on Home Equity Loans Is Still Deductible

QUESTION: Can you please tell me whether interest on home equity loans remains fully tax deductible or does the interest deduction apply only to first and second mortgages? This is particularly important to me because I know the interest deduction on consumer loans is fast fading, and I am thinking of using the proceeds from a home equity loan to pay off my consumer debt. I am hoping that this maneuver means that I will keep the interest deduction because the debt is now on my house, not the car. But with all the recent tax law changes, I am thoroughly confused. What’s going on?--B. K.

ANSWER: No wonder you’re confused: Very little involving the tax laws is simple these days.

Congress changed the rules when it adopted the Revenue Act of 1987. Under the new rules, deductible mortgage debt is divided into two categories: acquisition debt and home equity debt. Acquisition debt is simply the mortgage you incur either to purchase, build or substantially improve your primary or second home. This type of debt also includes refinancings of earlier mortgages. Like the acquisition debt, home equity debt is secured by your residence. However, the proceeds from the loan need not be used to acquire, build or improve the house.

For your purposes, however, the distinction between the two types of debts is largely irrelevant. The interest on a home equity loan is fully deductible so long as the loan does not exceed $100,000 or the difference between the fair market value of your home and your acquisition debt, whichever is less. For example, if the fair market value of your home is $140,000 and you already have a $70,000 mortgage on it, you may deduct the interest on a home equity loan only up to $70,000. These same limits apply in total whether you are taking out home equity loans on your primary residence or both your primary residence and a second home.

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One last note: Uncle Sam limits your acquisition mortgage interest deduction to the interest on a total of $1 million in mortgages if those debts were incurred after Oct. 13, 1987. There is no ceiling on the interest deduction for mortgages taken before that date, but there are special rules covering new refinancings of those mortgages.

Q: I have approximately $10,000 in matured Series EE savings bonds and would like to exchange them for Series H bonds. But I have not seen any mention of the Series H bonds in recent years and wonder if they are still being issued. Do you know anything about this?--E. C.

A: The bonds you are talking about are known today as Series HH bonds, but functionally they’re just like their predecessors, the Series H bonds. Basically, you are allowed to exchange your Series E or Series EE savings bonds for a comparable quantity of Series HH bonds and defer paying income tax on the interest accumulated by the original bonds. The only restriction is that these bond exchanges must be made in amounts of $500 or more.

However, you might want to rethink the proposed exchange. Unlike new Series EE bonds, whose interest is pegged to the current rates, Series HH bonds pay a flat 6% interest, year in and year out. In today’s market, this is not a terribly competitive rate, and you could earn more in an equally safe investment, including the Series EE bonds. However, you might be interested in exchanging your old bonds for HH bonds if you do not have the cash to cover the taxes on the interest your original Series EE bonds.

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By the way, are you absolutely sure that your original bonds have completely matured? In many cases, the expiration dates on these bonds is extended beyond their original maturity date. You might want to check.

If you are convinced that a bond swap is the best course for you, your local commercial bank should be able to help you. If your banker can’t help, write to the nearest Federal Reserve Bank and ask for form PD 3253, which will help you accomplish the exchange by mail.

Q: I will soon be receiving a $50,000 inheritance from by brother’s estate. My brother lived in New York state and his estate is being handled there. The executor assures me that because he is paying estate taxes to New York state, I owe no estate tax in California because the two states have reciprocity. He also says that I will owe no tax, either to the federal or California governments, on my inheritance. I can’t believe he is right. Is he?--S. M.

A: Yes. According to the Internal Revenue Service, your brother’s estate, not his heirs, is responsible for paying all applicable taxes on the assets he left. Once the estate taxes are paid by the estate’s executor, the remaining assets are divided according to the will and distributed tax-free to the heirs. California law matches federal law on this point.

There’s only one caveat: If you should inherit a piece of income property or other income-producing asset, such as securities, the income you receive in any given year from these assets is taxable to you as ordinary income.

Q: I sold my house last August and will be taking the one-time exclusion of $125,000 of the profits. For the last few years, my annual income has been so low that I have not been required to file an income tax return. My income was low in 1988 as well. But do I have to file an income tax return because I an using that exclusion?--M. J. R.

A: Yes, you must file an income tax return listing all your income and deductions because you are electing to use the profit exclusion available to senior citizens. In addition, you must also complete and file a Form 2119 along with your 1040. This additional form notifies the IRS that you sold your home and that you intend to shelter up to $125,000 of your profits. Filing these forms does not affect your tax obligations. If you would otherwise owe no taxes, your situation will not be changed.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.

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