Use the Tax Law to Reduce Your Debt

With consumer debt at record high levels and the national savings rate at a record low, it's no wonder that more and more people are concerned about reducing their debt. The key to trimming your debt is just like any other diet: Cut your spending as you would cut calories and exercise more -- in this case, exercise your self-control.

The similarity to a typical diet regimen doesn't end there: The remedy is often easier to explain than to execute. But once you commit yourself to your goal, there are ways you can use the tax laws to slim down your debts.

The interest you pay on consumer debt falls into two distinct categories: tax-deductible and non-deductible. Mortgage interest and home-equity loan interest are generally tax deductible. So is interest paid on student loans and money borrowed to buy investment property, including stocks, bonds and mutual funds, up to certain limits.

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Interest paid on credit cards and car loans is not deductible. In theory, using a home-equity loan to pay off high-interest credit card debt is a good idea. For example, trading $10,000 of 18% nondeductible credit-card debt for $10,000 of 7.5% deductible debt would slice the after-tax carrying cost from $1,800 to $540 a year for a taxpayer in the 28% bracket.

In reality, this strategy works best if you commit yourself to paying down your home-equity debt and claim the tax-deductible interest on your tax return as quickly as possible without allowing your zero-balance credit card statement to entice you to go on another shopping spree. Using your home as a piggy bank has its limits, and even tax-deductible interest cost money.

Home owners rejoice

Tax breaks for homeowners fall into three categories: when you buy, as you own and when you sell. Taking advantage of those tax breaks, and adjusting your tax withholding on your paychecks, or scaling back on your estimated quarterly tax payments if you are self-employed, will give you more money in your pocket each month to apply to your debts.

For most people, buying a home opens the door to a vast array of tax breaks in the form of itemized deductions. In 2008, individuals can claim a basic standard deduction of $5,450; for heads of households, it's $8,000; and for married couples filing a joint return, the standard deduction is $10,900. Homeowners who don’t itemize can boost their 2008 standard deduction by $500 (singles) or $1,000 (marrieds) to account for property taxes they pay.

Stack that up against a homeowner who might have $12,000 in mortgage interest plus $5,000 in local property taxes. In the 25% federal tax bracket, that combined $17,000 tax deduction saves you $4,250 a year. That's more than $350 a month in tax savings that you can apply to paying off your debts.

And once you start itemizing your deductions, you may be able to lower your tax bill even further by writing off charitable contributions, state income taxes and possibly medical bills. More tax savings means more money to pay down debts.

In contrast, a married couple in the 25% bracket claiming the standard deduction of $10,900 in 2008 would save only $2,725 in taxes.

While you own your home, you can borrow against your equity -- which is the difference between what you owe and what your house is worth. You can choose either a loan for a fixed amount, often tied to a fixed interest rate, or a line of credit that you can use at will, usually with a variable interest rates.

In most cases, you can deduct interest on up to $100,000 of home equity debt, regardless of how you spend the money. If you are subject to the alternative minimum tax, however, only interest on home equity debt used to buy, build or improve your home is tax deductible.

When you sell your home, up to $250,000 of profit ($500,000 for married couples filing jointly) is tax-free. Downsizing to a less-expensive home, particularly for new retirees, can be a great way to free up cash and pay off debts. To qualify for the tax-free profit, you must own and live in the house for at least two of the five years before the sale.

Student-loan interest

It's no secret that the cost of a college education is getting increasingly expensive and it is one of the biggest debts faced by recent college grads -- or their families. The good news is you can deduct up to $2,500 in interest you pay on qualified education loans for college or vocational school expenses, regardless of whether you itemize your deductions, subject to income limits. This tax break is known as an "above the line deduction" that lowers the amount of your income subject to tax. The deduction is available for loans to pay for educational expenses for you, your spouse or dependents.

For 2008, the deduction is phased out when modified adjusted gross income is between $55,000 and $70,000 for individuals and $115,000 and $145,000 for married couples filing jointly. For 2009, the income limits increase to a range of $120,000 to $150,000 for joint filers and remain the same at $60,000 to $75,000 for other taxpayers.

Investment interest

There's a corollary to the old adage "you have to spend money to make money." It's: "sometimes you have to borrow money to invest money." And if you do, the interest you pay on that borrowed money, in most cases, is tax deductible.

For the interest to be deductible, the investment has to be designed to produce taxable income. For example, interest on a margin loan from your broker to invest in stocks or taxable bonds qualifies. But if the borrowed money is used to invest in tax-exempt securities, the interest is not deductible. Ditto if you borrow to buy a single-premium life insurance policy or annuity. Congress doesn't want the IRS subsidizing loans to help you purchase tax-favored investments.

But there's a limit to how much investment interest you can deduct. The write-off is restricted to the amount of taxable investment income you report. Investment income is defined as interest, annuities or royalties, but not net capital gains or qualified dividends. (The government doesn't necessarily want you deducting investment interest in your regular tax bracket that may be as high as 35% if your gains are taxed at a maximum 15%.)

However, any interest you're unable to deduct because of the cap is not lost forever. It may be carried over to future years and deducted as soon as there is sufficient investment income to offset it, or on the final tax return after your death.