Mortgage Interest on Rental

[peggysioux]

Client has rental that they purchased in 2005. They have a loan that they can pay a low payment and the unpaid interest rolls into loan. Original loan began at $589,000 and loan is now up to $630,000. Would the additional $41,000 be considered personal equity and thus that percentage of interest non-deductible??

[Koss]

Mortgage Interest

Short answer: No.

The limitations on the deductibility of mortgage interest are applicable to mortgage loans on your principal residence and on a second home that you occupy. Those limits are not applicable to a loan that is secured by real estate other than your main or second home.

But there is a different question that may need to be addressed.

Were the proceeds of the loan in question used to buy, build or improve the rental property? Is the loan in question the original loan that they took out when they bought the rental? If so, then all the interest should be deductible.

Refinancing in and of itself does not change the rules. But if they refinanced at some point and took cash out, and used the extra money to pay college tuition, or take a vacation, or for some other purpose that is unrelated to the rental property...

Well, then you are dealing with interest tracing rules.

When it comes to a loan on a rental property, the issue is not whether the loan balance, or the loan proceeds, exceed the value of the property. That is only an issue with a mortgage loan on your main or second home. The issue with your client's loan is whether the loan proceeds were used exclusively for the business of operating the rental property. If they were, then there's no problem.

At the risk of belaboring the point:

Suppose your client owns a rental property worth $250,000, and it's already mortgaged to the hilt. Your client may have excellent credit and lots of other assets. Your client can go out and get an unsecured loan for, say, $100,000. If he uses that money to improve the rental property, all the interest from that loan is fully deductible on Schedule E. It's a business loan that is directly tied to the business of Schedule E.

On a smaller scale, your client can even deduct credit card interest for purchases that are associated with the rental property. But unless he has a separate credit card account that is used only for the rental property, it's not worth fooling around with.

[peggysioux]

Mortgage Interest on Rental

The increase in the loan is due to taxpayer not paying full interest each month so the interest just rolls into loan. This client has a $630,000 loan and $65,000 in mortgage interest. So, to clarify your explanation, being they have not taken any money from equity in rental and used for other than rental, all would be deductible, correct??

[Koss]

Negative Amortization

The increase in the loan is due to taxpayer not paying full interest each month so the interest just rolls into loan. This client has a $630,000 loan and $65,000 in mortgage interest. So, to clarify your explanation, being they have not taken any money from equity in rental and used for other than rental, all would be deductible, correct??

Yes. If the proceeds of the loan were used exclusively for the rental property, then all the interest should be deductible.

[oceanlovin'ea]

Similar situation

I had a similar situation this year. I have a client that has 2 rental properties. Actually they have 2 LLC's with a rental property in each of them. (beside the point, I guess).
They also pay a minimum payment and it does not cover the interest accruing on the loan each month. So their loan balance continues to go up each month.
Last year their 1098 showed mortgage interest that was the amount of mortgage interest that was charged on the loan and we took that deduction.
This year the 1098 only showed as mortgage interest the amount that they had paid during the year. I talked to her about it and she called the bank (Washington Mutual) and they said that the 1098 was correct. you can only deduct interest that you actually pay.

So the difference in the interest is a deferred account and they will get to take the interest when they finally pay the interest.

It was very confusing to me. Since my husband works for a large firm, he talked to the head of the accounting department and he explained it to him.

Linda F

[S T]

Negative Amortization

While the t/p is not making the full principle payment, or the interest payment as in a "regular" fixed loan amount, it seems that both deferred principle and interest are being added to the outstanding loan balance.

So how can you deduct negative interest on the form 1098 that hasn't been paid.
I am seeing some 1098 forms come through now with huge amounts of interest on them, but it is due to the fact that the loan was refinanced, and the deferred principle and the deferred interest were rolled over into the new loan. Does that constitute paying the interest on the old loan? Doesn't seem correct. It hasn't been paid, it has just been rolled over into a new loan and eating up more equity.

Sandy

[Koss]

Cash vs. Accrual

I think I misunderstood the original post. I was focused on what appeared to be a question about whether the interest would somehow be considered nondeductible personal interest.

It is interest on a business loan, and it is fully deductible. The question is when.

On the cash method, you can only deduct interest in the year that it is actually paid. So it would not be deductible if it was merely added to the loan balance.

On the accrual method, the interest is deductible in the year the interest actually accrued, regardless of whether it was actually paid.

[S T]

Still

So, if it is a Partnership or S Corp, etc, that is on accrual, then they would be able to deduct all of the interest paid or not in the year posted on the 1098.

However, most individuals whether it is personal residence, or Schedule E rentals are all cash basis, and these negative amortizations are being reported on the form 1098 usually when a refinance occurs.

I might be wrong, but the only time I have deducted the negative amortization and accrued interest is when it has been a (cash - individual) and they sold the property and all was paid off at the time of disposition.

I just had one that was $36,000 interest on the form 1098. Rental property was refinanced and new loan obtained. After obtaining the information from the prior lender, we found that (approximate numbers) $3,200 was actual interest paid in the tax year, $10,000 was for a prepayment penalty and the balance $22,800 was negative amortization interest that had been included. So how much would you deduct for interest paid on the Schedule E? (Individual with one rental unit)

Sandy

Interesting subject and more problems with reporting mortgage interest on Schedule A and Schedule E for cash basis taxpayers.

Sandy

[peggysioux]

Mortgage Interest on Rental

I think the reason for the interest being so high this year ($65,000) is due to the fact that the client refi'd and thus the first mortgage company deemed the negative interest paid at the time of refi. Normally, when a taxpayer has negative interest, the 1098's only include paid interest in box 1, but shows deferred interest in another part of the 1098. These mortgages and refi's have become an absolute nightmare in California. So, are there any rulings regarding how the negative interest is to be handled on rental?????

[Snaggletooth]

Disagree

I disagree with the eminent and ever-loquacious Koss.

I don't think an individual can deduct interest unless it is paid, regardless of
accounting method.

If the original loan was $589,000, then that is the basis, and all that can be
depreciated. The taxpayer has paid $41,000 less interest than has been
accrued into the loan, and is only entitled to the interest actually paid.
Taxpayer has made no financial transactions to entitle him to additional
basis.

Should he SELL when the loan is $630,000, then the additional $41,000
becomes either additional basis, or deductible interest -- I don't know which.
The above choice is important since deductible interest could apply against
ordinary income and additional basis would simply lower capital gains.

So I fashion myself as answering one question, and leaving another unanswered.