Limited Mortgage Interest Deduction

[Kram BergGold]

My client has a 1,000,000 mortgage on a second home. They have no mortgage on their primary residence. The second home is rented out 70 days a year and used personally 40 days. Am I correct that my first step is to divide $750,000 by $1,000,000 and then multiply 75% times the interest and then allocate that amount of interest between Schedules A and E?

[New York Enrolled Agent]

I think you need to use average balances to get the correct ratio. Take a look at the worksheet in Pub 936.

[Rapid Robert]

I think Pub 527 and its worksheets are a more appropriate first place to look.

To determine if any of the mortgage interest is deductible on Schedule A, we need to know if any of the $1M mortgage is acquisition debt, and if so was it originated before or after the TCJA deadline (Dec. 2017)? There is no mortgage interest limitation for rental property like there is for use as a personal residence, so I don't believe any $750K limit would apply to the rental portion. However, only acquisition debt would be deductible for a rental, not equity debt.

After determining the rental expense allocation, then you might have to look at applying personal mortgage deduction limits per Pub 936 to the personal portion.

(Obviously interest tracing will not be part of this scenario). EDIT: or will it? I mean, even though it is a single physical residence, could the "2nd home" personal mortgage be treated as not secured by the residence, and then traced entirely to the rental activity? (might help if taxpayers itemized deductions are limited, or if they benefit more from reducing AGI than taxable income).

NOTE: Pub 527 contradicts what I just wrote, so I guess I'm wrong, but I think my position has more logical justification.

"If you are itemizing your deductions on Schedule A, figure the amount of mortgage interest to include on line 2a by using the following steps.

Step 1. Treat all the mortgage interest you paid for mortgages secured by your home(s) as a personal expense and figure the amount that would be deductible as an itemized expense on Schedule A. See Pub. 936 for more information about figuring the home mortgage interest deduction and the limits that may apply.

Step 2. Include on line 2a the rental portion of deductible mortgage interest figured in Step 1 that is attributable to the home you are renting."

Now as to the allocation between Schedule A to Schedule E, the rental pub gives a worksheet. Basically your allocation factor is 70 / [ 70 + 40 ] = 63.6%

"In general, your rental expenses will be no more than your total expenses multiplied by a fraction, the denominator of which is the total number of days the dwelling unit is used and the numerator of which is the total number of days actually rented at a fair rental price."

[Rapid Robert]

Re-reading, I may be over-thinking this. The items I mentioned all need to be considered -- but yes, to determine how the $750K limit affects a mortgage with an acquisition debt balance higher than that, you will want to use the table in the home mortgage pub. Or, "You can use the highest mortgage balances during the year, but you may benefit most by using the average balances." The Form 1098 will report the beginning of year balance, so it's easy to determine if you want to just use the highest balance, assuming the mortgage balance always gets paid down (no negative amortization).