Loan allocations upon repayment

[mactoolsix]

When a T/P pays down a mortgage which has been allocated for several uses, where does acquisition interest fall in the Loan Repayment timing order given in Pub 535:
1. Personal Use
2. Investments & passive activities
3. Passive rental R/E activities
4. Former passive activities
5. Trade or Business use and low-income housing

I've always thought of acquisition (and equity) interest as "personal" interest until I read Sec 163(h)(2)D which specifically states "any qualified residence interest . . ." is NOT personal interest.

Since acquisition & equity interest is not one or the five items listed under the Loan Repayment timing order, can we reduce these in any order that best suits the T/P's situation? or in what order should they be reduced?

[mactoolsix]

Why reduce the acquistion debt last

Maybe this will spur some answers.

The client has a sizable amount allocated to investment debt, and also some acquisition debt. The investment debt is merely creating investment interest carryovers which we feel he may never be able to use. He has managed to pay off a substantial amount of the loan, and we would like to re-allocate to reduce the investment allocation.

We are trying to locate a reference that says we can first reduce the investment allocation before reducing the acquisition allocation.

Thanks, Mike

[Lion]

Use vs.interest

Personal use is what he has of his personal residence. Personal interest is interest for property that doesn't qualify for qualified mortgage interest, cars, etc. You're mixing the type of loan with the type of property.

[mactoolsix]

Interpretation

Personal use is what he has of his personal residence. Personal interest is interest for property that doesn't qualify for qualified mortgage interest, cars, etc. You're mixing the type of loan with the type of property.

Thus the Section 163(h)(2) is simply distinguishing items that do not qualify for the interest deduction; which means this section is not referencing the "Personal Use" listed in Pub 535 under Loan Repayment order.

Would you consider that acquisition debt is "Personal Use" and must be eliminated first when re-allocating?

Thanks,
Mike

[S T]

For what is worth

I use CFS Tax Tools, and track several clients that have mixed use mortgages.

If I follow the directions on CFS tax tools, it always lists the first to final in order and then gives me the allocation

Always on the split amounts gives me a note: Allocation of home mortgage interest to other than qualifed residence interest reqires an election per IRC 1.163-8T(n): IRC 1.163-10T

Review Pub 535 - Home Loan Tracing Worksheet and gives me this

The following is from IRS Publication 535:

If you use the proceeds of a loan for more than one purpose (for example, personal and business), allocate the interest on the loan to each use. Note: The allocation of interest paid on debt secured by a qualified residence to another use requires an election per IRC 1.163-8T(n) and IRC 1.163-10T.

When any part of a loan allocated to more than one use is repaid, the loan is treated as being repaid in the following order.

1) Amounts allocated to personal/home mortgage use.

2) Amounts allocated to investments and passive activities (other than those included in (3) below).

3) Amounts allocated to passive activities in connection with a rental real estate activity in which you actively participate.

4) Amounts allocated to former passive activities.

5) Amounts allocated to trade or business use and to expenses for certain low-income housing projects.

This module allocates interest and determines amounts repaid by category for any year following receipt of the loan proceeds and disbursement to the various uses. Monthly principal reduction (MPR) is assumed to be equal to annual principal reduction divided by twelve.

Hope this helps some

Sandy

[mactoolsix]

Pub 535 . . .

Sandy, - Thank you, this is what I'm looking for . .


When I look up Pub 535, I do not find "Home Loan Tracing Worksheet." And the "repaid in the following order" list shows

1) Amounts allocated to personal use.

It does not reference "personal/home mortgage use."

Do you have a link to this quote?

Thanks,

[solomon]

I've always thought of acquisition (and equity) interest as "personal" interest until I read Sec 163(h)(2)D which specifically states "any qualified residence interest . . ." is NOT personal interest.

The Code you cite is in the context of what is or is not deductible interest. That is, personal interest is not deductible and acquisition interest is not considered personal interest for this purpose.

On the other hand, when allocation and tracing of interest under §1.163-8T is the context rather than deductible interest, then "personal expenditure" includes acquisition debt and interest - although not subject to tracing.

§1.163-8T(b)

(5) “Personal expenditure” means an expenditure that is not a trade or business expenditure, a passive activity expenditure, or an investment expenditure.

[S T]

From CFS

Interest Allocation for Subsequent Years

This module calculates interest allocations for years after the first year of the loan. For calculating the first year see Interest Allocation for First Year.

Also see the following related modules.

Home Loan Tracing Worksheet documents the use of funds on property loans.

Qualified Loan Limit, Deductible Mortgage/AMT Interest Limits calculates deductible home mortgage interest limits for a particular year.

The following is from IRS Publication 535:

If you use the proceeds of a loan for more than one purpose (for example, personal and business), allocate the interest on the loan to each use. Note: The allocation of interest paid on debt secured by a qualified residence to another use requires an election per IRC 1.163-8T(n) and IRC 1.163-10T.

When any part of a loan allocated to more than one use is repaid, the loan is treated as being repaid in the following order.

1) Amounts allocated to personal/home mortgage use.

2) Amounts allocated to investments and passive activities (other than those included in (3) below).

3) Amounts allocated to passive activities in connection with a rental real estate activity in which you actively participate.

4) Amounts allocated to former passive activities.

5) Amounts allocated to trade or business use and to expenses for certain low-income housing projects.

This module allocates interest and determines amounts repaid by category for any year following receipt of the loan proceeds and disbursement to the various uses. Monthly principal reduction (MPR) is assumed to be equal to annual principal reduction divided by twelve.

CALCULATIONS:

Average Monthly balances are first determined for each category. Monthly principal reduction is applied to the lowest-numbered category until (and if) that category is reduced to zero. If the total reduction in principal for the year is greater than the initial balance of the lowest-numbered category, that balance is reduced to zero before year-end and monthly payments are then applied to the next lowest-numbered category. The principal balances for higher-numbered categories will not change during the year unless the balances for lower-numbered categories are reduced to zero. Monthly balances are assumed to be the end-of-month balances. Therefore, the January balance for the lowest-numbered category is equal to the initial balance less the monthly principal reduction.

Average annual balances for each category are then calculated as the sum of the monthly balances divided by twelve. (Computation of monthly balances is illustrated in IRS Publication 936.)

Interest is then allocated to the various categories in direct proportion to the average principal balances.

If you review Pub 535, starts about page 11 - Allocation of Interest

I believe what I posted on the "Home Loan Tracing Worksheet" is within the CFS Tax Tools Module - sorry

Does this help?

Sandy

[mactoolsix]

Sandy - I appreciate your reply. We have CFS Tax Tools at the office and I will take time Monday to review them. As always you've been very helpfull!

Solomon - I read and reread Section 163-8T(b) - Thank you for the cite!! I don't understand your last item "- although not subject to tracing."

On the other hand, when allocation and tracing of interest under §1.163-8T is the context rather than deductible interest, then "personal expenditure" includes acquisition debt and interest - although not subject to tracing.

So does acquisition interest fall under the "1. Personal Use" section, but is not subject to tracing? How does that work?
Mike

[S T]

Had and issue with this

You know I had an issue with this around 2008, CFS TaxTools changed their worksheets, (Only been using for the last 8-10 years) you might also want to give them a call.

Use to have Categories such as , personal, Investment/Passive, Rental/Active,
Part/ Former Passive, Trade or Business and Home Mortgage.
Then in about 2008 CFS changes and combined the Personal/Home Mortgage into one category. Really messed me up, as I had some clients that I was tracking over-limit of their acquisition debt and $100K equity debt. .

Keep us informed on what you find out, I would be curious also to know.

Sandy

[mactoolsix]

Final Determination

With much thanks to Lion, Solomon and Sandy, and postings on Tax Almanac from RoyDaleOne:

"The tracing rules do not apply to qualified residence interest, which is defined by reference to the security for the loan (i.e., the taxpayer's residence). Reg. Section 1.163-8T(m)(3)."

Sec. 1.163-8T
(m) Coordination with other provisions—

(3) Qualified residence interest. Qualified residence interest (within the meaning of section 163(h)(3)) is allowable as a deduction without regard to the manner in which such interest expense is allocated under the rules of this section. In addition, qualified residence interest is not taken into account in determining the income or loss from any activity for purposes of section 469 or in determining the amount of investment interest for purposes of section 163(d). The following example illustrates the rule in this paragraph (m)(3):

Example. Taxpayer E, an individual, incurs a $20,000 debt secured by a residence and immediately uses the proceeds to purchase an automobile exclusively for E's personal use. Under the rules in this section, the debt and interest expense on the debt are allocated to a personal expenditure. If, however, the interest on the debt is qualified residence interest within the meaning of section 163(h)(3), the interest is not treated as personal interest for purposes of section 163(h).

Comment:
Regs. Sec. 1.163-8T. Allocation of interest expense among expenditures (Temporary)
The court cases most of the time treat qualified residence interest as outside the allocation rules, thus, such debt is not covered by the 163 Regulations. This line of reasoning could give 1. that qualified residence debt would be (vi) in the above list, or 2. that because qualified residence debt is not subject to the tracing rules the taxpayer can allocate the debt reduction to the acquisition debt or not.
This seems to consistence with the rules, because of the order and nature of debt covered by the regulation above.

Thus since qualified residence interest does not fall within one of the Pub 535 ordering list, it is not necessary to consider qualified residence interest when applying the ordering for reallocation.

It appears from the above cites, that although it may usually be the best option, CFS Tax Tools is misleading when it combines "Personal/Home Mortgage into one category.

Thanks again for everyones input!