Home Equity Loan for Rental Property

[NotEasy]

I know you can only itemize the interest of a home equity loan up to $100,000 of loan balance in Schedule A.

But if the home equity loan is used as down payment to purchase a rental property, does the $100,000 limit still apply?

[Lion]

It doesn't matter what the use of the funds is, as long as the use is not the buying, building, or improving of a primary or secondary residence. So, whether using the proceeds to purchase a rental building or invest in a business or take a vacation, the limits are the same for schedule A and AMT.

[Gary2]

It doesn't matter what the use of the funds is, as long as the use is not the buying, building, or improving of a primary or secondary residence. So, whether using the proceeds to purchase a rental building or invest in a business or take a vacation, the limits are the same for schedule A and AMT.

I disagree. It doesn't make sense to say that if you use a home equity loan to buy a rental property, you can only deduct interest on $100,000, but if you use a margin loan (or a home equity loan on a third residence), then interest tracing kicks in and you can deduct the interest on the full amount.

I'm pretty sure that if you can trace the interest to the rental, then there's no dollar limit on the amount of the loan or deduction. Some more interesting questions are can you deduct the full amount on Sch. E (which you might want if there's not enough total deductions to itemize) and must you deduct the full amount on Sch. E (which you wouldn't want, if passive activity loss limits kick in).

And I'm not going to get into the discussion about whether one must explicitly make an election to treat the interest this way. Search for 1.163-10T(0)(5)

[Roberts]

I use this piece I got from Bankrate.com:

If you use the proceeds from a home equity loan to purchase a rental property, the interest would be deductible on Schedule E as an expense to produce rental income. If you use the proceeds to purchase investments, such as stocks, you may be able to claim the interest as an itemized deduction on Schedule A for investment-related expenses. If you use the proceeds in your business, the interest on the loan would be deductible as a business expense on Schedule C. If used the proceeds on your farm, you could deduct the interest on Schedule F. And if you used a home equity loan to pay for qualifying education expenses, you could claim a deduction for student loan interest.

[Kram BergGold]

Trace the interest

You trace the interest and attach a statement to the tax return which details
the amount traced
the date it started
the interst rate,
name of lender,
what type of loan,
and the term of the loan.

Be advised once this election is made it is irrevocable so if the rental property is sold and the debt is not retired the interest would be personal and non deductible. Or if the rental property becomes a residence the interest would not be deductible.

[appelman]

I believe the relevant election...

Is to treat the loan as not being secured by the home. As Kram says, it is irrevocable. Also, it must be the whole loan, not a part of it.

[Gary2]

Since the point about the election being irrevocable has been made, I'll add that the debate concerning this has to do with whether a formal election is required to apply the traceability rules. If you're allowed to trace the interest regardless, without making a formal election, then the rule about it being irrevocable doesn't apply. I won't venture an opinion on this, but will again refer people to a very long discussion on that other popular board, with the unhelpful title of "Summer school midterm exam question", dating back two years ago.

I will, however, disagree with the point that any such election must be for the entire loan. The election is to choose to treat a debt as not being qualified residence interest. Debt that exceeds the limits for residence interest is already not qualified residence interest, and thus it makes no sense to elect to exclude it from something that it doesn't qualify for. The regs make this a bit more complicated because they provide two alternatives for calculating the qualifying interest, one of which does require that the excess be treated as non-deductible personal interest. See 1.163-10T, specifically paragraphs (d) "Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Simplified method" and (e) "Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Exact method", particularly (e)(4) and all the examples under both (d) and (e). Caution: I haven't read the entire text of this regulation, so although I believe (e)(4) is straightforward enough, there might be something else getting in the way.

[Burke]

I will, however, disagree with the point that any such election must be for the entire loan.

I tend to agree with this statement. For instance, when an equity loan is taken on a residence already paid for, where it does not exceed the original purchase price, and a portion is used to purchase rental property and the rest is used for other purposes, whether improvements to the primary residence or consolidation of otherwise non-deductible debt. The applicable percentages would apply to the various forms to which it is appropriate and authorized under the IRC, IMO. If there is some reg which opposes this position, please let me know.

[Gretel]

I agree also that one can choose the dollar amount for the election (called 10-T election). It is irrevocable but if the use of funds ever change (let's say you convert a rental to a home) then the way how you take the interest deduction also changes.

[NotEasy]

Thank you for all the replies.

You trace the interest and attach a statement to the tax return which details
the amount traced
the date it started
the interst rate,
name of lender,
what type of loan,
and the term of the loan.

Be advised once this election is made it is irrevocable so if the rental property is sold and the debt is not retired the interest would be personal and non deductible. Or if the rental property becomes a residence the interest would not be deductible.

Just want to confirm I understand this correctly. So if the taxpayer trace the interest to the rental property, the full amount of the home equity loan interest will be deductible even if the loan amount exceeds $100,000?

[Gary2]

Thank you for all the replies.

Just want to confirm I understand this correctly. So if the taxpayer trace the interest to the rental property, the full amount of the home equity loan interest will be deductible even if the loan amount exceeds $100,000?

This is correct. There is no disagreement that it's possible and legal to deduct the full amount of the traceable home equity interest, if it's done correctly. I suggest taking the time to read the full 10T regulation mentioned previously. In particular, avoid the trap of the "Simplified method" I mentioned previously, and any similar traps (since that part of the reg is focused on acquisition debt, not home equity debt).

Whatever disagreement exists concerns whether an explicit election is required and what it applies to.

[Kram BergGold]

Let's be clear

The amount you elect to trace to the rental has no limit and the interest applicable to that debt is deducted on Schedule E. Any remainng debt that you are calling home equity debt (this is debt used for purposes other than improving the first or second house the debt has been taken out on is subject to the 100k limit. This assumes you are ok with the idea that the election is not an all or nothing deal as some of the responders believe is the case.