Investment Interest - change in use of funds?

[Gretel]

Something was brought to my attention in a recent conference that I might have misunderstood.

A loan was taken our on a rental property, rental was sold but loan was not paid off. Loan combined with another loan on another property (loan for 2nd property was increased). I considered the allocated interest expenses from the loan balance from the first property to be non-deductible personal interest expense since the TP choose to not pay off the loan. However, the loan belonged the property sold and the interest might still be considered mortgage interest on that property (to be taken as the only expense for that property until paid off).

What do you think? Even if it is still legitimate mortgage interest I surely hesitate to file a Sch. E for years just showing mortgage interest.

[Snaggletooth]

What about an example?

Sometimes it is helpful to add numbers so we can think this thing out.

Assume rental property generated the need for a $100,000 loan with interest at 5%. Doesn't necessarily matter whether the rental property was collateral because you say they sold the rental property without having to pay off the loan. Because the proceeds were used to buy the rental property, the interest was deductible every year on Sch E. So now the rental property is gone and let's just say there is $80,000 remaining on the loan.

Now you say the loan is combined with another loan. Just to add numbers, let's say there is another loan for $120,000 that the taxpayer borrowed to buy a bulldozer for his farm. Merging the loans gives a new principal of $200,000. Going forward 60% of the interest is deductible on Sch F (or Form 4835), and 40% applies to the rental property where there is no longer any Sch E income to apply the interest.

I don't believe the taxpayer having the opportunity to pay off the rental loan has anything to do with it. Obviously, the $80,000 in principle remaining now is serving a different purpose than when it was borrowed, but we need to stick with the original purpose.

Since the rental property is gone, I believe Form 4952 might be appropriate, giving rise to a Sch A deduction. There is something about using the 4952 which affects capital gains, but the "gains" whatever they are, are now gone.

Would like to hear from others.

[AZUKHiker]

Regulations Have Answer

Have a look at 1.163-8T(j). That explains what to do with reallocations and has a couple of examples.

[Gretel]

Thank you, both. I read the regs before posting but could not clearly understand them. I re-read and my conclusion is now that it depends on how the proceeds (that could have been used to pay for the original debt) are used and tracked, pretty much same as other cash out loans.

If used for another investment property and following the interest tracing rules, then this part of the interest expenses can be deducted as investment interest expenses. However, if either used for personal means, or not properly tracked, then this interest is non-deductible personal interest.

Please someone confirm my understanding.

Thanks,

[AZUKHiker]

I agree that it depends on what the proceeds are used for, which makes sense if the original loan is not paid off.