New Chief Counsel Advice Changes Way Election to Trace Home Equity Borrowing Works

Reg.§1.163-10T(o)(5) allows the homeowner to elect to trace proceeds from a home loan to their use. This is an advantage when the taxpayer uses refinance proceeds for his or her business, investments, rentals, etc. Tracing is especially advantageous if the taxpayer is in AMT since interest on equity borrowing is not deductible in computing AMTI. 
 
The Chief Counsel advice clarifies that if an election is made, the entire proceeds of the refinance must be traced.  If an election is not made, the proceeds are first considered equity borrowing and only the amounts over the $100,000 debt equity limit can be traced.
 
News.  In the past, we thought that if an election was not made, the interest above the $100,000 equity borrowing amount would be considered personal interest.  The CCA clarifies that the interest is traced according to the rules in Reg. §1.163-8(T).
 
Example.  Sharon borrows $150,000 from her home’s equity and deposits the proceeds into her business account to pay business bills.  She does not include an election under Reg. §1.163-10T(o)(5) with her Form 1040.  Sharon must allocate interest to Schedule A as equity borrowing to the extent of $100,000 (assuming she has not already borrowed from her house).  The balance of interest can be traced to her Schedule C and deducted as a business interest expense.

Planning point.  Failing to make an election may be to the taxpayer’s advantage if the proceeds are used to buy a rental (and if the client is not in AMT). Since passive rules can often suspend any rental loss, Schedule A interest deduction may result in lower  current tax.
 
Example.  Sharon borrows $150,000 from her home’s equity and deposits the proceeds into her business account to pay business bills.  She includes an election under Reg. §1.163-10T(o)(5) with her Form 1040. Sharon can deduct interest on the entire $150,000 loan as business interest expense.

The "10-T” Election to Treat Debt as Not Secured
by the Taxpayer’s Qualified Home Should Be Made in Writing

Sample Election Statement Under Reg. Sec. 1.163-10T(o)(5)

Taxpayer Name: Joe Client
Social Security Number: 999-99-9999
Form: 1040
Tax Year Ending: 12/31/11
 
The taxpayer elects to treat $150,000 of home equity debt, the proceeds of which were used to purchase equipment and supplies for his business, as trade or business debt.
 
The interest on this debt for the tax year was $6,175 and is reported on Line 16b of Schedule C.