Equity Stripping and Taxes

Filed under: offshore

Of course, where there is interest – even deferred interest and balloon payments – taxes are an issue. Taxes must be paid on interest payments (and on accrued but unpaid interest too in most cases), and the interest, may not be deductible to the payor. So, even in the case of a husband and wife who are lender and borrower, the lending spouse will have interest income, and the borrower spouse may not get an interest deduction. This is an issue whether or not the spouses file a joint return. If the interest payments are not deductible, then a tax liability that did not exist previously may have been created.

Certainly, if the interest income is being reported correctly to the IRS, it may help establish the validity of the loan. Conversely, if there is no such reporting, the arrangement will appear to be a sham. Indeed, many equity stripping arrangements are unwound because of the tax treatment of the interest on the loan.

To avoid the tax problems, equity stripping arrangements might be implemented using a grantor trust as the counter-party, so for tax purposes, it is a nullity. Of course, this gives a later creditor the chance to come in and argue, “Well, if it is a nullity from a tax standpoint, then it should be a nullity from a civil standpoint too.” Though logically suspect, this sort of rationalization may appeal to judges.

With a personal residence, keep in mind that for a home equity line of credit, only the interest on the first $100,000 is deductible. This may substantially impair the economics of many programs that are designed to equity strip personal residences. At any rate, you should never equity strip a primary residence unless there are funds immediately available somewhere with which to make mortgage payments.

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