Mortgage Used For Home & Rental

[GTS1101]

I may have asked this question before so forgive me if this is a duplicate. I tried looking at the board under mortgage limits and I couldn't find anything similar.

Client refinances main home and takes out 100,000 to invest in a rental property. Original loan was 400,000. New loan is 500,000. Can the client choice not to treat the 100,000 as secured by the main home and deduct 20% of the mortgage interest on Sch E? If yes how do you make this election? Pub 936 explains the choice but it doesn't say how to do it. Do you just attach an explanation to the return?

Thanks!

[Roland Slugg]

Not a choice

Dear GTS1101

It's not a choice at all. It's mandatory. The tracing rules require that mixed-use loans be allocated according to the funds' use.

There are no elections or other statements that I'm aware of, but a little summary of how the proceeds were used would be a good thing to put in the file. Of course, the interest will have to be allocated each year, and I suggest you (or the client) keep a running amortization schedule. That way if either the residence portion or the rental portion of the loan principal is paid down, the remaining interest can still be figured and allocated correctly for each side of the loan. This would be an easy thing to do using an Excel or QuattroPro spreadsheet.

[Gretel]

Also keep in mind that you have to follow the ordering rules (Reg. 1.163-8T(d)(1), which say: When loan proceeds are for mixed use, the principal is treated as repaid in the following order: 1. Personal expenditures 2.-4. not important in this scenario, 5. Trade or business expenditure.

[GTS1101]

Thank You

Thank you for your help. These rules on mixed mortgages and mortgage & equity limits can be very difficult to understand. Thanks for your guidance.

[les grans]

According to IRS the election is exactly as you state it. IIRC, you attach a statement, and it might help to cite the regulation that *appears* to allow this election.
Here's what the IRS publication says:

Choice to treat the debt as not secured by your home. You can choose to treat any debt secured by your qualified home as not secured by the home. This treatment begins with the tax year for which you make the choice and continues for all later tax years. You can revoke your choice only with the consent of the Internal Revenue Service (IRS).

You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest.


And here's what the regulation [Reg Sec 1.163-10T(o)(5)] says (including an example...!):

(5) Election to treat debt as not secured by a qualified residence —(i) In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

(ii) Example. T owns a principal residence with a fair market value of $75,000 and an adjusted purchase price of $40,000. In 1988, debt A, the proceeds of which were used to purchase the residence, has an average balance of $15,000. The proceeds of debt B, which is secured by a second mortgage on the property, are allocable to T's trade or business under §1.163–8T and has an average balance of $25,000. In 1988, T incurs debt C, which is also secured by T's principal residence and which has an average balance in 1988 of $5,000. In the absence of an election to treat debt B as unsecured, the applicable debt limit for debt C in 1988 under paragraph (e) of this section would be zero dollars ($40,000−$15,000−$25,000) and none of the interest paid on debt C would be qualified residence interest. If, however, T makes or has previously made an election pursuant to paragraph (o)(5)(i) of this section to treat debt B as not secured by the residence, the applicable debt limit for debt C would be $25,000 ($40,000−$15,000), and all of the interest paid on debt C during the taxable year would be qualified residence interest. Since the proceeds of debt B are allocable to T's trade or business under §1.163–8T, interest on debt B may be deductible under other sections of the Internal Revenue Code.

[les grans]

Follow Up on money borrowed against the house for use in the business....

I feel I should point out that this regulation is over twenty years old, it is a "temporary" regulation, and it was written to explain a version of IRC section 163(h) that no longer exists. [Note, for example, the reference to the "applicable debt limit" in the example in this regulation; there was an "applicable debt limitation" in 1987, but it disappeared from the tax law almost immediately.]

Does someone here know if there's any clear (or even unclear...) authority for looking to either the "tracing rules," or the qualified residence rules, *first*, to identify which type of indebtedness this ambiguous "secured by the residence but used for business/investment/rental" debt is? [The relevant IRS publication is not the level of authority I'm seeking... :-) ]

[GTS1101]

Follow up to responses

This is even more confusing than when I first started. I have never been so challenged in the tax law before.

Let's say a equity line is taken out on the main home for 70,000. 41,000 is used to invest in a rental property. 29,000 is used to payoff credit cards. There is also the 1st loan existing that is not over the acquisition limit. She has used 53,000 of that equity for credit cards on that loan. 1st was for 331,000. 60,000 used for home improvements.

123,000 of equity used is over the 100,000 limit. But according to the pargraph in Pub 936 it says that:

"You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible(for example, as a business expense) whether or not it quailifes as home mortgage interest. This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest."

In my understanding this does not go over the acquistion limits or the equity limits because if the client chooses to treat the 41,000 as not secured by the home it is not subject to the acquistion and equity limits. Therefore my understanding is that you would take 41,000/70,000 and deduct 59% of the interest on Sch E and 41% on Sch A. There is no need to do the average balance method because she is not over the limits.

Any ideas or comments?