Equity used to buy 2nd home

[appelman]

A client borrowed against his main home to buy a 2nd home. Is there any way he can treat this as anything other than equity debt? I think not, but suggestions are welcome.

[Snaggletooth]

Why a Second Home?

If the 2nd home is just a second (and not primary) residence, I think this is treated just like any other second mortgage, limited to the interest on $100,000 on Schedule A.

If the 2nd home is to be used as rental property, there may be some relief -- but I'm not positive the $100,000 limit is lifted. Clearly if the money trail of the loan is for a rental house, the interest may be deducted on Schedule E, possibly without limit.

However, assume the rental property becomes victim to the passive rules and a loss must be suspended via Form 8582. In that case, it might make better sense to not deduct the interest on Sch E, but on Sch A instead. That might convert a Sch E loss into a profit, avoid the passive trap and 8582, and then get the full benefit of the interest deduction on Sch A.

I believe home equity loans can be deducted where the funds are used (Sch C, F, E), but the taxpayer always has the option of trumping these options by deducting instead on Sch A.

[Burke]

However, assume the rental property becomes victim to the passive rules and a loss must be suspended via Form 8582. In that case, it might make better sense to not deduct the interest on Sch E, but on Sch A instead. That might convert a Sch E loss into a profit, avoid the passive trap and 8582, and then get the full benefit of the interest deduction on Sch A. I believe home equity loans can be deducted where the funds are used (Sch C, F, E), but the taxpayer always has the option of trumping these options by deducting instead on Sch A.

I think you are right as far as it goes. But I was under the opinion, that once the election is made to deduct it elsewhere and it is traced to that property use, you could not switch back and forth. For instance, debt used to buy rental property, but interest deducted on A for a number of years, then ---- oops, not enough to itemize any more, switch interest to Sche E. Or vice-versa. Switch interest taken on Sche E in the past to A to enable itemizing. About the situation where home equity debt used to buy second home, then down the road converted to rental, that might work since debt was originally traced to that property. If anyone has a cite, let me know.

[taxxcpa]

Rental interest on Sch A

If you deduct rental expense (interest) on Schedule A, you are deductiong it in the wrong place, and should be able to do it correctly in the future and deduct it on Schedule E.

It may or may not be any tax effect that would warrant filing an amended return for the years it was done incorrectly. I see no point in an amended return that would not change the tax, but, I, personally, do file amended returns sometimes with no change in tax to get the record straight.

[appelman]

Who said anything about rental?

Since Schedule A mortgage interest must be on a loan secured by the property. my take is that since this loan was secured by the principal home, it remains an equity loan on the principal home. In particular, it cannot be treated as acquisition debt on the second home. Am I right? IMHO it was a very poor idea for the taxpayer to go about it this way, since he is subject to AMT and therefore gets no interest deduction at all on equity debt.

[Snaggletooth]

Prior Treatment

But I was under the opinion, that once the election is made to deduct it elsewhere and it is traced to that property use, you could not switch back and forth. If anyone has a cite, let me know.

Burke, I don't have a cite, but am relying on previous discussions on this forum. The proceeds were used for one purpose, and that purpose does not change from year-to-year. However, I do believe Sch A treatment is always available, and would be the lone exception to changing the arena-of-deduction. and the election to use Sch A is not binding on the following year.

Since I don't have a cite, would love for someone to address this with authoritative information. "Previous Discussions on this forum" itself is not as good as a cite, obviously.

[S T]

Dave Fogel has an article on this (although it has to do with a Sched C)
see http://www.fogelcpa.com/Documents/CS...EquityDebt.pdf

Then also found this

The QRI dollar limits on deductions prescribed under Sec. 163(h)(3)(B)(ii) and (C)(i) bar taxpayers from deducting excess interest payments. QRI included in itemized deductions Itemized Deduction

A deduction from a taxpayer's taxable adjusted gross income that is made up of deductions for money spent on certain goods and services throughout the year. also may be limited in the case of high-income taxpayers. There are certain circumstances in which home-equity debt proceeds could be used to allow interest to be deductible under other Code provisions. Temp. Regs. Sec. 1.163-10T(o)(5) provides that a taxpayer may elect to treat home-equity debt as not secured by a residence.

Election

By making tiffs election, the taxpayer frees the debt from the QRI dollar limit, making it available for another interest deduction Interest deduction

An interest expense, such as interest on a margin account, that is allowed as a deduction for tax purposes. , if applicable. Thus, if interest is deductible regardless of whether it is QRI, electing out of QRI treatment preserves the deduction for interest on other debts deductible only if it is QRI. For purposes of Temp. Regs. Sec. 1.16310T(o)(5), a taxpayer may elect to treat any debt secured by a qualified residence as not secured by such residence.

The election is effective for the tax year for which made and for all subsequent tax years, unless revoked with IRS consent. While deducting the interest on the appropriate forms and/or lines is sufficient under the regulations to perfect the election, taxpayers are advised to make the election in a separate statement attached to the return.

Sandy

[Burke]

Good job! Thanks.

[Snaggletooth]

Burke is Correct

Thanks Sandy. Looks like Burke is correct.

1. Taxpayer has choice of using the interest to follow the purpose of the proceeds (C, F, E whatever) and if there is such a use, then it is freed of all typical HELOC/2nd mortgage restrictions.
2. Taxpayer can choose to deduct on Sch A regardless of the purpose, but invokes all the restrictions.
3. After choosing among the above options, taxpayer CANNOT go back and forth having established character of the interest.

If, as Appleman says, it is just a second home and not being used for anything except a second home, it is Sch A stuff and the restrictions apply.

[Burke]

I found the Fogel article very enlightening. Especially about a HELOC taken for multiple uses and how that is treated. I did not know that, and have the very same situation he describes. Now I can advise the client to do separate loans, or a 2nd mtge. Love this board.