I did as you said and had TurboTax calculate the expense deductions for me but I think that TurboTax is making a mistake. To use some example numbers:
Rental is 15% of our total square footage.
Total interest was $51,000.
TurboTax attributed $7,650 to the rental
Turbotax transferred $43,350 to Schedule A and used this amount for the deduction
Loan balance - $1.8 million
The trouble is that that when letting TurboTax calculate everything, it never asks that last question about loan balance. In this case, the balance of the loan is higher than $750,000 so it seems to me that only a percentage of the $43,350 it's trying to deduct on Schedule A would actually be allowed.
For example, when I manually enter the interest for the rental, then enter the deduction using my 1098 on the Deductions and Credits screen, then TurboTax asks for the loan details. TurboTax limits the deduction to about $21,000 due to the large loan balance. If I do it this way I think I need to reduce the 1098 interest by the amount that was entered on Schedule E but I'm not sure. I am also not sure how much of the remaining interest should actually be deducted. I don't think it's as simple as multiplying the interest by 750,000/mortgage balance since that fails to account for the rental property in any way.
Not sure if it's consequential, but per IRS Publication 936 we don't fit the definition of "renting out part of our home" since the cottage is totally separate living quarters. So that might mean that we need to assume "divided use" of our home but the publication doesn't provide example for how to account for that in terms of the mortgage deduction.
@HopeS
