Borrowed Interest

[Nashville]

This comes from a previous thread, whose original question morphed into this situation.

Is borrowing (i.e. not paying) to cover interest considered deductible?

Joan borrows $300,000 and falls on hard times. She makes no payments, and over the course of a few months, this loan accrues $15,000 interest. Her fortunes reverse dramatically, and now the bank is convinced she can make payments if they make her a NEW loan.

The new loan is for $315,000 because the unpaid interest became part of the new loan.

Which of the following is true?

a) Joan cannot deduct any part of the interest because she hasn't paid any.
b) Joan may deduct ALL of the interest because borrowing to pay interest is deemed to have paid the interest.

As a side question, does it make any difference if this interest is for her personal residence or if she is a business taxpayer (Sch C) on an accrual basis?

[ChEAr$]

This comes from a previous thread, whose original question morphed into this situation.

Is borrowing (i.e. not paying) to cover interest considered deductible?

Joan borrows $300,000 and falls on hard times. She makes no payments, and over the course of a few months, this loan accrues $15,000 interest. Her fortunes reverse dramatically, and now the bank is convinced she can make payments if they make her a NEW loan.

The new loan is for $315,000 because the unpaid interest became part of the new loan.

Which of the following is true?

a) Joan cannot deduct any part of the interest because she hasn't paid any.
b) Joan may deduct ALL of the interest because borrowing to pay interest is deemed to have paid the interest.

As a side question, does it make any difference if this interest is for her personal residence or if she is a business taxpayer (Sch C) on an accrual basis?

If personal interest no deduction of course.
If borrowed as, say, a second equity line of credit, still no deduction cause none paid
merely by having been rolled over into new loan.

If borrowed for business, still no deduction for lack of economic reality.

[Earl]

Interest

Previous reply to previous thread

This compares to Student Loan Interest in that unpaid interest is capitalized into loan. When student makes payment on loan all of the payment is considered first applied to the capitalized interest for purposes of deducting student loan interest. When capitalized interest is completely paid off then only interest applied to original loan is deducted.

However, don't know whether this would apply to the above scenario.

[Nashville]

Thanks Earl

I did read your response to the student loan interest, and thank you for your interest in this subject.

One interesting corollary to this is if you are the bank and have to issue a 1098, how much do you issue as deductible interest?

Joan has borrowed the $315,000 in July after defaulting on the original $300,000 loan. She begins paying in August and doesn't miss any payments on the "new" loan. The $15,000 additional was for accrued interest between the making of the first loan, which was never paid. The amortization schedule for the new loan says that for this year, she paid $2800 in principal from August to December 31 and $5800 in interest, $7600 in total payments.

We now have a three way possibility (if anyone is keeping up with this and has the mental perseverance to follow the numbers). I would hate to be the bank and have to be responsible for issuing the 1098..

a. Joan can deduct $15,000 because the new loan is "deemed" to have paid the accrued
interest, but then cannot deduct the $5800 interest on the amortization schedule.
b. Joan cannot deduct the $15,000 because she didn't pay it, but she CAN deduct the $5800 because she did pay this much.
c. Under Earl's example for student loans, Joan cannot deduct the $15,000 but can deduct the $7600 in total payments because the first $15,000 in payments of any kind apply to the $15,000 FIRST, and thereafter may deduct the interest as scheduled on the orginal payment plan.

I don't know that I can choose from the foregoing. My guess many of you don't either, and this thread will sink quickly to the bottom and into oblivion...

[jimenright]

interest was paid

The interest was paid by the borrower whether or not the funds came from a loan. Other rules regarding deductions for interest apply.

[Davc]

I think the interest would have been paid only if the refi was from a different institution.

[thomtax]

Don't know what the exact wording in technicalities of tax law may be (there seem to be exceptions to every law in taxes) but just something to think about.

Could it be construed that the bank loaned her $15,000. This money was then used by her to pay on the debt. In that case, she being a cash basis taxpayer, could it be construed that she actually did pay the $15,000.

I can't say how it is supposed to be interpreted, but just another wrinkle.

LT

[Snaggletooth]

Thank You

A big thank you to all who offered on opinion on this matter, and to Dave1980 from the other thread. Looks like there are as many opinions as there are possibilities. I wouldn't know where to begin to look for cites - I believe there may be multiple cites which conflict with one another.