Using a HELOC for a private / intra-family loan - IRS AFR vs my HELOC interest rate; and are my interest payments deductible?

[magiklamp]

I'm thinking of using my HELOC to make an intra-family loan. 

I am familiar with most of the requirements to make the intra-family loan bona fide in the eyes of the IRS, but I do have one specific question about that: I know that the interest I charge should be at least that which is published by the IRS as AFR (https://www.irs.gov/applicable-federal-rates).  Say for example the AFR according to the IRS is 2%, but the interest that I have to pay on my HELOC is 3.5%.  Is it okay for the interest rate on the intra-family loan to be 2% when I'm actually paying 3.5% for the cash that I've lent?

Also, I understand that HELOC interest can be deductible if used for an investment if I make the election to "choose to treat any debt secured by your qualified home as not secured by the home”

(https://www.therealestatecpa.com/blog/who-said-you-cant-de[product key removed]est-interest-tracing-...).  In my case, if I'm using the HELOC to loan cash to someone else, I'm guessing the only way I can deduct my HELOC interest is if the interest rate for the private loan is greater than the interest rate I'm paying for my HELOC--is that correct?  And if that is correct, and say my HELOC interest is 3.5% and the interest I charge for the private loan is 3.75%, can I deduct the full 3.5% interest that I'm paying?

[MinhT1]

1. Your HELOC interest is not deductible if you use the proceeds for a family. The HELOC interest is only deductible as Mortgage interest only if you use the proceeds to buy, build or substantially improve your home that secures the loan, This does not at all depend on the interest you charge for your family loan. The exception you mentioned only applies when you use the proceeds for a business.

2. You are free to charge any reasonable rate of interest for your personal loan. But please note that you have to report any interest you receive as interest income on your personal tax return.

[magiklamp]

Thank you for your reply.  In regard to the exception I mentioned ("Choice to treat the debt as not secured by your home. You can choose to treat any debt secured by your qualified home as not secured by the home" (IRS Publication 936)),  are you sure the exception only qualifies when the money is used for a business?  The reason I ask is because in IRS Publication 936 I read the following:

Mortgage proceeds used for business or investment. If your home mortgage interest deduction is limited under the rules explained in Part II, but all or part of the mortgage proceeds were used for business, investment, or other deductible activities, see Table 2 near the end of this publication. It shows where to deduct the part of your excess interest that is for those activities. The Table 1 Instructions for line 16 in Part II explain how to divide the excess interest among the activities for which the mortgage proceeds were used.

Which I interpret to mean that there exist more ways to qualify for the exception besides strictly "business."

If I'm not taking that portion of the publication out of context, then wouldn't a private loan I make using my HELOC money count as an investment for which I can deduct the HELOC interest?  As in the following example, found on the webpage I referenced in my OP:

For example, you take $100k out of your HELOC with a 5% interest rate and provide a hard-money to another investor at 10%. Assuming you don't have any other investment expenses, the $5,000 in interest from your HELOC will be tax deductible because it is less than your $10,000 in investment income.

[AliciaP1]

The key phrase is "deductible activity".  It has to be something that funds tax deductible amounts.  A loan to a family member is not an investment unless the family member is making you a part owner in a business they are starting with your "investment".

In your example, if the amount was funded by money other than your HELOC, there would be no deduction available.  Therefore, even if you use HELOC funds, the funds are not invested in a "deductible activity" and cannot be deducted from your return.