Home Mortgage Interest Tracing

[Kram BergGold]

Taxpayer refinances home for $250,000. Uses $100,000 to pay off the mortgage on a rental property. Can he make the election to treat $100,000 as not secured by the residence and thereby deduct on Schedule E but leave $150,000 as home acquisition debt? I fear one has to elect out for the entire mortgage.

[appelman]

Home Mortgage Interest Tracing

You are right that the loan cannot be split. They might have been better off with two loans, e.g a 1st and 2nd TD. However, any of the loan interest that exceeds the allowable Schedule A deduction may be allocated to another use by the general interest tracing rules.

[Gretel]

I respectfully disagree. The tracing rules apply, so in this case, if the mortgage for the rental was all used to purchase or improve rental, than that part of the new mortgage can be deducted on Schedule E. You have to make a 10-T election, which is irrevocable.

[appelman]

That isn't what the question said.

That isn't what the question said. 100K of a 250K refinance of a home was used to pay off mortgage on a rental. Client can elect to treat the entire 250K as not secured by the home, but not a part of it. The correct solution would have been to take out a150K 1st TD and a 100K 2nd TD and make the election on the 2nd.

[Jesse]

Taxpayer refinances home for $250,000. Uses $100,000 to pay off the mortgage on a rental property. Can he make the election to treat $100,000 as not secured by the residence and thereby deduct on Schedule E but leave $150,000 as home acquisition debt? I fear one has to elect out for the entire mortgage.

I have searched for an answer to this question in the past and have not found anything solid to confirm or deny whether a taxpayer can make the election with regard to only a portion of a debt. Any other thoughts?

[Gretel]

Here is a link that addresses the issue:

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

In an audit for one of my clients, the auditor allocated part of one mortgage to the Sch. C activity. Would this be good enough to hold up in court? I don't know.

Since this issue is not addressed I don't see anything that speaks against allocating part of the home mortgage interest to biz. I believe the most important issue are the tracing rules.

[DaveO]

Good link Gretel, thanks.

I can only offer an anecdotal case myself, albeit an extreme one. I had an audit a few years ago for a fellow with a very complex return. Among the issues was interest deduction. He had about a dozen various loans throughout the year. Some secured by his home others secured by UCC filings on his business assets. I constructed a matrix allocating the interest from each loan in full or in part to one of 2 Schedule “C” or to one of two 8829’s or to his “A”. The use of the loans was a combination of personal and real property plus operating capital. The audit was conducted by a revenue officer who gave me tons of grief about most everything else on the return but he accepted the interest allocation without question. Of course we had all the loan documents to back up the interest. The taxpayer had self-prepared his returns and had made a number of technical errors that cost him dearly. We actually found more interest than was originally claimed and had no problem getting it allowed.

Naturally one auditor’s forbearance is not indicative of another’s.

[Gretel]

I think, in general, the IRS is very impressed with spreadsheets and they come to or over the edge of their knowledge pretty easy.

Which now brings back to memory, that I am certain you can prorate one loan. You have to follow certain ordering rules in which part of the loan is paid back first and cannot just prorate the interest. Very complicated. Neither my auditor, nor me, nor you, nor lots of people are following these rules. But that they exist proofs that one loan can be prorated. Ha. I have to do something about my memory though.

[Jesse]

Thanks much for the feedback!

[appelman]

Living dangerously

Based on the link that Gretel provided, I still think it would be living dangerously to count on being able to treat only part of a home loan as not secured by the home. Again, of course, interest that is disallowed as home loan interest can always be allocated to other uses.

[JG EA]

Based on the link that Gretel provided, I still think it would be living dangerously to count on being able to treat only part of a home loan as not secured by the home. Again, of course, interest that is disallowed as home loan interest can always be allocated to other uses.

Dangerous? I'm going to have to think about this. All TTB e.g.'s seem to show it is possible to trace.

Tracing seemed to me in the past to be pretty straight forward. I looked at it simply: The tracing rules do not apply to Home Mortgage Interest so people may deduct more Home Mortgage Interest. Not for the purpose of not being able to trace interest.
In Pub 535 it states:

The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan's proceeds... In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses...The easiest way to trace disbursements to specific uses is to keep the proceeds of a particular loan separate from any other funds.

[My thought - But not the only way.]

If the property that secures the loan is your home, you generally do not allocate the loan proceeds or the related interest. The interest is usually deductible as qualified home mortgage interest, regardless of how the loan proceeds are used. For more information, see Publication 936.

[My thought - Usually - because you can already deduct it as Home Mortgage Interest, but not that you have to.]

[DaveO]

Very good point appelman. If the interest is not home mortgage then it can be something else.

In the case of my audit I was forcing the numbers to match what the taxpayer had reported on his return. I expected a challenge (because most everything else was challenged) but was happy I didn't have to mount a defense on this issue.