@NCperson wrote:
@Opus 17 -in this query, the home equity proceeds from the primary residence went toward improvements on the investment property.
While everything you wrote (as usual) is quite clear, I was hoping you were going to also clarify and confirm that the home improvements you were referencing were solely related to improvements on the primary residence being sold and could not include improvements to the investent property, even though the home equity from the primary residence was the source of the cash used to improve the investment property, regardless of how they were paid for.
What we have here is a complicated mixed situation.
Regarding the personal residence, the HELOC by itself does not change (raise or lower) the capital gains on the sale of the personal residence. That's what I was primarily responding to. The cost basis of the personal home is based on it's purchase price and any improvements made to the personal home only.
Regarding the rental property, the improvements made to the rental property are listed as assets and added to the adjusted cost basis, and they are deprecated over 27.5 years, which allows the owner of the rental property to take a gradual tax deduction for the cost of the improvements. If we want to talk about the rental cost basis and capital gains on the rental, that's an entirely different post.
Now, some readers may be thinking of the HELOC interest. If the HELOC was not used to improve the taxpayer's personal home, by which it was secured, then none of the interest is deductible as home mortgage interest on Schedule A. However, if the HELOC was used to improve the rental property, the interest may be allowable as a rental expense on schedule E, assuming the taxpayer can use the tracing rules to properly allocate the interest expense to the rental property. (The loan does not have to be secured by the rental property to be a rental expense, if the tracing rules are followed.) But, since the HELOC will be paid off as part of the sale of the personal residence, there will be no further ability to deduct interest as a rental expense, since there is no more interest available to be allocated to the rental property.
Going back to the top post,
Does a HELOC payoff at settlement reduce our capital gain?
No. See publication 523 and the previous answers.
And if so, should we max out the HELOC before we sell, since we are still in the draw period, to reduce this capital gain obligation?
That is irrelevant. Drawing the HELOC will only change the time at which you receive the proceeds from the home sale, not the capital gains calculation. You might draw $500,000 now and receive nothing further at settlement or you might leave the HELOC alone and receive $500,000 at settlement. It doesn't change the gain calculation.
However, to obtain maximum benefit from the rental property, you should not draw on the HELOC from the personal home to make improvements on the rental property, because when you sell the personal home, you won't be able to deduct interest as a rental expense. You should try and borrow against the rental to make improvements on the rental, since that way you can deduct the interest as a rental expense.
