mortgage interest tracing rules

[nwtaxlady]

My client took out $100,000 equity loan on personal residence back in the Spring and the money is in a savings account. Now they are buying a rental property and want to pay cash using the $100,000. Can they deduct this mortgage interest on the Sch E for the rental property? When I looked up the tracing rules it mentions a 30 day period to use the $$. In my clients case it will be 6-9 months that they would be using the funds. What do you think? Deductible on Sch E to offset the rental income? Or tell the client to put down 20% to avoid PMI then finance the rest on the rental property itself?

[solomon]

Without looking, I gather it is secured by the personal residence and was not treated as not secured by such. Therefore, I think it will still have to remain on Sch A subject to an AMT adjustment.

[S T]

Pub 535

Try Pub 535 page 11 and See TTB page 4-14 etc

Sandy

[veritas]

two options

I believe you have two options. One is Sch A home equity or Sch A investment interest.

[taxxcpa]

Options

I believe you have two options. One is Sch A home equity or Sch A investment interest.

You could pay the 20% down, borrow the rest secured by the rent house, pay off $80,000 of the home equity loan. You would need to evaluate the interest rates and other re-financing costs to determine if re-financing would be worthwhile.

If you paid cash for the house, it might be possible to deduct the interest on Schedule E beginning with the first payment after the acquisition. That seems logical but I would check the IRS rules before doing it that way since the rules aren't always based entirely on logic.

In any case all interest before acquisition would go on Schedule A.

[Gretel]

Without looking, I gather it is secured by the personal residence and was not treated as not secured by such. Therefore, I think it will still have to remain on Sch A subject to an AMT adjustment.

I believe the election to treat home mortgage interest as not secured by home can be made any time. You cannot revoke election without consent, though.

[solomon]

I believe the election to treat home mortgage interest as not secured by home can be made any time. You cannot revoke election without consent, though.

I should have read first. You are correct. §1.163-10T(o)(5) and the example thereunder does verify it. Thanks for the education.

[solomon]

Interesting article.

http://www.taxacte.com/nl9801.htm

[Nashville]

New Loan

How about borrowing $100,000 on a new loan to buy the rental house. Then take the $100,000 in savings and apply to current residence?

Without question moves the interest to a schedule E instead of schedule A. The taxpayer retains his exact economic position.

Upside: Deduction is "above the line" if deductible on schedule E, resulting in greater tax savings than itemized deductions due to guaranteed deductibility and not-so-guaranteed if used as an itemized deduction due to threshholds and phaseouts.

Downside: If passive loss rules apply to this taxpayer, deduction could be wasted even if it's "above the line." In such a case the deduction is not lost forever, but rolls forward to apply to future income or gain on sale. If gain on sale, has the effect of converting capital gains into ordinary income, which is the REVERSE of all good tax planning.

[AuditorTurnedGood]

If gain on sale, has the effect of converting capital gains into ordinary income, which is the REVERSE of all good tax planning.

Isn't a rental property section 1231 property, allowing for capital treatment of gains and ordinary treatment of losses? I'm pretty sure that is correct.

ATG

[Nashville]

Yes, but

Isn't a rental property section 1231 property, allowing for capital treatment of gains and ordinary treatment of losses? I'm pretty sure that is correct.
ATG

ATG you are correct, but the effect of compiling disallowed rental losses into your basis means that you are eating into capital gains when you sell instead of being able to deduct the interest against ordinary income currently. You have to think it through mathematically to see this.

Example: You buy $100,000 of rental property and over the course of 10 yrs. accumulate some $30,000 in operating losses that you are not able to deduct (This includes depreciation which is an "operating" expense. Depreciation recapture will be treated the same whether the operating losses were allowed or not, so it is not a factor). Your "basis" is now $130,000.

After 10 years you sell this property for $180,000 and have a capital gain of $50,000. Without the suspended losses your capital gain would have been $80,000. So what has happened is that instead of offsetting ordinary income for $30K over the course of 10 years, you are now offsetting capital gains by $30,000. Deducting the $30,000 may have benefitted you 35%-39% during those years. Offsetting the capital gains by $30,000 will benefit the taxpayer a maximum of 15%.

[Bees Knees]

My client took out $100,000 equity loan on personal residence back in the Spring and the money is in a savings account. Now they are buying a rental property and want to pay cash using the $100,000. Can they deduct this mortgage interest on the Sch E for the rental property? When I looked up the tracing rules it mentions a 30 day period to use the $$. In my clients case it will be 6-9 months that they would be using the funds. What do you think? Deductible on Sch E to offset the rental income? Or tell the client to put down 20% to avoid PMI then finance the rest on the rental property itself?

It depends upon whether other money was in the savings account at the time the $100,000 was put into it, and other funds were withdrawn during the 6-9 month period. When the 30 day rule no longer applies to the tracing rules, you have to use the rules mentioned in IRS Pub 535.

The Pub gives the following example:

Example. Connie, a calendar-year tax-
payer, borrows $100,000 on January 4 and im-
mediately uses the proceeds to open a checking
account. No other amounts are deposited in the
account during the year and no part of the loan
principal is repaid during the year. On April 2,
Connie uses $20,000 from the checking account
for a passive activity expenditure. On September 4,
Connie uses an additional $40,000 from
the account for personal purposes.

Under the interest allocation rules, the entire
$100,000 loan is treated as property held for
investment for the period from January 4
through April 1. From April 2 through September
3, Connie must treat $20,000 of the loan as used
in the passive activity and $80,000 of the loan as
property held for investment. From September 4
through December 31, she must treat $40,000
of the loan as used for personal purposes,
$20,000 as used in the passive activity, and
$40,000 as property held for investment.

Keep in mind that if you cannot trace the interest under these rules mentioned in Pub 535, it can ONLY be treated as Home Equity interest, or non-deductible personal interest. Investment interest must follow the same tracing rules that would apply to your Schedule E activity, so treating it as investment interest on Schedule A is irrelevant. If it can't be treated as Schedule E interest, it cannot be treated as investment interest.