Mortgage Interest

[Rickie]

My client borrowed money from a person and put his residential rental home up as collateral. Since the loan is secured by the home I was thinking it might be deductible on Sch E (?)But, from what I have read, I don't think I can. I'm reading in the Tax Book Tab 4-10 "Any interest paid on a qualified home". Definition of a qualified home is the main or second home (my client has 0 personal use). Obviously, this is Rental property and I think since it's not directly related or to acquire or improve the home it isn't deductible (?). Can anyone point me to the right answer?

[DaveinTexas]

I hate to post a link but...

this is hands down the best way to answer your exact question: https://www.google.com/url?sa=t&rct=...3WZ_JA&cad=rja

Now, whether or not the loan qualifies as a home equity loan....I don't know the answer. That might be a borderline legal question and a review of your State laws might be necessary.

[Rickie]

mortgage interest.

That didn't really help because the loan had nothing to do with the rental other than the loan was secured by the rental. However, that was good info. Thank you.

[DaveinTexas]

Longer Answer

You're right, I forgot to RTDQ; my bad.

Here is the long answer:
When cash is received from a refinance, the deductibility of the interest on the underlying loan depends on the way those proceeds are used. This loan- and interest-allocation process is known as interest tracing, and it is essential to computing interest deductions each tax year.

For rental properties, all proceeds received in a refinance must be traced in order to determine the deductibility of interest. The loan proceeds should be categorized according to the following types (in an order from best to worst tax treatment): (1) trade or business, (2) investment or portfolio, and (3) personal. The interest deduction will depend on which of these categories the proceeds were used. For example, if the proceeds were used to invest in the taxpayer’s business, the interest on those loan proceeds would be considered a business expense for that business. If the proceeds were reinvested in the existing rental property by making improvements, the interest deduction would remain with the property and be deducted in the same manner as the original mortgage. If the refinance proceeds were invested in a new rental property, the related interest expense would be deducted against the income on that new property. If the proceeds were used for personal use (to pay for a vacation or children’s education expenses), the interest on those proceeds would be nondeductible. As a tax-planning strategy, any principal payments against a refinanced loan should be applied in the reverse order of the above-mentioned types—first to personal interest and then finally to trade or business interest. Typically, rental properties are subject to the passive-activity loss limitation rules.

Generally, the proceeds used to pay off the existing mortgage will maintain the same character as the original loan. For example, if the existing mortgage is secured by the property and was originally taken out to purchase the property, the debt (and the refinance proceeds used to pay off the original debt) will be considered acquisition indebtedness, and the interest on that debt is deductible.

As an example: If you take out the equity of a rental house you own, you can’t automatically deduct the interest on that rental’s Schedule E. If you use the loan to replace the roof and renovate the rental property, then indeed you can deduct the interest on that rental’s Schedule E. If you use it as down payment on another rental property, you may deduct it on that new rental’s Schedule E. If you use it for a cruise around the world, it’s personal interest and not deductible at all. If you invest it in securities, it is potentially deductible under the rules for investment interest. If you are self-employed and use it for your business, it would be deducted on your business Schedule C. And so on. If you use the proceeds for several different purposes, you have to allocate the interest among those several uses, and deduct it (or not) according to the rules for each use.

And yet, even more examples for you: https://www.google.com/url?sa=t&rct=...BLOWKQ&cad=rja