Financing is often an issue of concern when starting a new business or expanding an existing one. A good place to start is with the Small Business Administration (SBA). However, many entrepreneurs prefer to use the equity in their homes, which will probably provide a lower interest rate and a longer payback period.

If you are considering such a move, be aware that there are complications when you borrow against your home and use the funds for business. The interest paid on home mortgages that are secured by the taxpayer’s home is by definition home mortgage interest and, as such, can only be deducted as home mortgage interest. In addition, home mortgage interest cannot be allocated to other uses to the extent it is allowable, either as interest on acquisition debt or as the first $100,000 of equity debt interest. Excess debt interest (interest on debt that exceeds the deductible debt limits) can be allocated to other uses under the general tracing rules.

Why is that a problem? There are two reasons: (1) you can only deduct home mortgage interest if you itemize your deductions, so if you deduct the standard allowance, you receive no benefit for the business interest; and (2) interest deducted on your business schedule offsets both income and self-employment tax—not to mention other tax benefits if you are unfortunate enough to have a loss, but mortgage interest deducted on Schedule A is not allowed as a deduction in computing the self-employment tax.

What is the solution? If you have already exceeded your home mortgage debt limits, you can go ahead and take more equity out and allocate the interest to your business. If not, you can utilize the “unsecured election,” which allows taxpayers to treat the loan as unsecured, and then use the general tax tracing rules and allocate the business portion of the interest back to your business. There is one pitfall to this election.

If the loan is mixed-use (part home and part business), then the home portion of the interest can no longer be deducted as home mortgage interest, since by definition a home mortgage must be secured by the home. A solution to that would be to take a separate loan on the home for the business debt, even though the interest rate might be slightly higher.

If you are in need of business capital and are considering refinancing your home, please call our office for assistance. We will gladly address all of your concerns.