Can I deduct the interest on a cash out refinance if I used the cash to buy a rental property ?

[inbb2b]

We are retired and own our home. We took a cash out refi to buy a small rental property cash.

Can I use this interest as an expense on Sched E of my rental property since loan was only used to acquire the rental ?

[DawnC]

Yes, you can claim it on Schedule E as a rental expense.  There is no personal deduction on Schedule A, however.  

[pk]

@inbb2b , what I understand from your post is that (a) you did a cash-out refinance of your  main home; (b) you used all/part of the proceeds to buy a rental property all cash.  If this is  true , then  ( and here I am disagreeing with  @DawnC  ) you CANNOT use the interest payments as rental expense.  This is because  the interest payment is deductible ONLY if it is secured by the property.  In your case ( as I stated above ) it is secured by your residence.  Hence  this expense ( interest expense ) is  deductible ( when itemized ) against your  home , not against the  rental property.

A lawyer could help you set up a trust/LLC etc so that you can indeed deduct this mortgage interest in total without  having to itemize. 

[NCperson]

@pk - there has been a variance of opinion on this topic in many threads over the past few months.  

There is one camp that shares your opinion that the interest is not deductible for the reasons you state.

There is another camp that states that because of 'tracing', the interest is deductible onto Schedule E, but certainly not deductible on Schedule A.  Similarly, if the money was used to invest in a business, the interest would be deductible on Schedule C.   But if the money was used to buy a vacation property, it would not be deductible because there is no 'tracing;' to Schedule A permitted, which is where interest on the vacation property would otherwise go.

[pk]

@NCperson , @DawnC , as I read through 26USC163,  agree that there is the possibility of different interpretation  because of the use of "properly allocable"  i.e. the question becomes can  an interest  payment  ( prorated )  that is secured  by a residence , be allocated to the "use" -----  I maintain, and absent case law,  that "allocation " to business use is not  qualified .   Thus  it is not deductible as an expense to the business.  I agree the situation would be different if the business signed  a loan agreement  showing that there is an indebtedness  for the amount on which an interest is being paid.  That is why I suggested seeing a lawyer to set up a  securitization so the  interest payment can be passed through.  Absent that I am not persuaded that the residential loan interest can be "allowably allocated" to a business venture.  I am attaching  relevant portion of the 26USC 163 below -- the full text is available at LII Cornel -- https://www.law.cornell.edu/uscode/text/26/163

26USC.163.

(h)Disallowance of deduction for personal interest

(1)In general

In the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year.

(2)Personal interestFor purposes of this subsection, the term “personal interest” means any interest allowable as a deduction under this chapter other than—

(A)

interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee),

further down:

26.USC.163.

(3)Qualified residence interestFor purposes of this subsection—

(A)In generalThe term “qualified residence interest” means any interest which is paid or accrued during the taxable year on—

(i)

acquisition indebtedness with respect to any qualified residence of the taxpayer, or

(ii)

home equity indebtedness with respect to any qualified residence of the taxpayer.

For purposes of the preceding sentence, the determination of whether any property is a qualified residence of the taxpayer shall be made as of the time the interest is accrued.

(B)Acquisition indebtedness

(i)In generalThe term “acquisition indebtedness” means any indebtedness which—

(I)

is incurred in acquiring, constructing, or substantially improving anyqualified residence of the taxpayer, and

(II)

is secured by such residence.

[Opus 17]

It's clearly not schedule A interest, which is what that section of the code covers.  But where does it say for schedule E (or schedule C) that interest payments on a business loan must be secured by the business or its property? 

[Opus 17]

Pub 535.

Allocation of Interest

The rules for deducting interest vary, depending on whether the loan proceeds are used for busi- ness, personal, or investment activities. If you use the proceeds of a loan for more than one type of expense, you must allocate the interest based on the use of the loan's proceeds.

Secured loan. The allocation of loan proceeds and the related interest is not generally affected by the use of property that secures the loan.

Interest You Can Deduct

Your trade or business interest expense may be limited. See the Instructions for Form 8990 for more information. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan.

[NCperson]

I don't believe the point is that the loan must be secured by a business loan (schedule C or E)

the tracing argument is that if the loan is secured by the home (cash out refi) and then money was used to fund a business endeavor, then the money is not deductible on Schedule A, since it was not used to improve the home that the loan collateralized, HOWEVER, because of tracing rules, it would be deductible on Schedule C because the money was used in a business.  

Similarly a cashout on your primary residence with the proceeds used to purchase a 2nd home would not qualify as deductible interest as it would have to go on Schedule A.

[pk]

Generally agreeing with both @NCperson  &  @Opus 17   whereas 26CFR 1.163-8T does  allow and require allocation of interest   ( for expensing purposes ) based on allocation of "loan amount " usage,  what I struggle with is  how do you trace  ( and  prove  ) the distribution of funds acquired  through a refinance ( cash-out) to various business ventures especially when the life of the refinanced loan is different than the life of the investment.  That is why I stayed with the simplistic  view of   stopping  refinanced loan  at the  home mortgage , to the extent it is used for qualified purposes.  And also suggested  the  poster to see a lawyer and set up a structure  ( flow through or  otherwise ) such that the  monies  loaned to the  investments are  traceable  through direct loans  from  the investor., essentially allowing subrogation of the loan  interest

[drk95]

My wife & I are retired.  In 2019 we did a cash out loan on a second home which we own. We used all of that money to purchase a townhouse as a rental property. We were remodeling it for most of 2020 and finally had renters move in 8/2020.  We did not claim any Schedule A interest on that loan in 2020. Both the properties are titled in our trust along with our primary residence. 

Can I deduct the loan payment on the 2nd home loan as a business expense on the rental property for 2021?

[Opus 17]

---

@drk95 wrote:

My wife & I are retired.  In 2019 we did a cash out loan on a second home which we own. We used all of that money to purchase a townhouse as a rental property. We were remodeling it for most of 2020 and finally had renters move in 8/2020.  We did not claim any Schedule A interest on that loan in 2020. Both the properties are titled in our trust along with our primary residence. 

Can I deduct the loan payment on the 2nd home loan as a business expense on the rental property for 2021?

---

You are posting at the bottom of a 2 year old discussion.  You should read the entire thing.

You can deduct interest on a loan used to improve rental property as a rental expense, even if the loan is not specifically secured by the rental property.  However, you must be able to trace the loan dollars so that you can allocate the interest to the rental property.  As long as the HELOC is only used for the rental property, that allocation and tracing is straightforward.  But if you use the loan proceeds for other things, it becomes more and more complicated, and your deduction becomes more at risk in case of audit.  It all comes down to how reliably you can trace the loan proceeds and allocate the interest as a rental expense. 

[Mac1287]

@Opus 17 , I'm sorry for hijacking the thread but seeing as you seem to be knowledgeable with interest tracing rules, I wanted to see if you could review a question I had regarding calculation methods for allocating deductible interest.

My original question is posted here:

https://ttlc.intuit.com/community/investments-and-rental-properties/discussion/re-how-do-i-calculate...

Note: Please review the equation in the latest response (posted Friday 3/18/2022) for the correct ratios related to the example provided.

[JillS56]

Yes, the equations in your 3/18/2022 post seem to be correct to get the percentage of interest before June 2021 and after June 2021.   

I do have a question for you to clarify.   This refinance was on a rental property you owned and you took out cash to purchase a second rental property, correct?

Just to be clear, you can deduct interest on a loan used to improve rental property as a rental expense, even if the loan is not specifically secured by the rental property.

[Opus 17]

@inbb2b 

I replied at your original location.

In reference to @JillS56 's question,

I believe you refinanced property A with the intent to purchase property B, but that never happened.  In that event, if you use a portion of the remaining cash to improve property A, that will increase the percentage of deductible interest on the new loan.  You don't have to worry about the tracing rules.

However, if you use the leftover cash from property A to now purchase or improve property C, D or E, that interest is legally deductible (a loan to improve property C does not have to be secured by property C), but whether you can actually survive an audit will depend on being able to clearly trace the interest expenditure on the loan against property A to an improvement of property C. 

[Mac1287]

Thank you both @JillS56 and @Opus 17 .  I really appreciate the help.

@Opus 17 : You are correct, the money was pulled out from the refi in order to purchase a second rental property (Property B), but the deal fell through and the money has since been sitting in the bank as we look for a new property to invest in.

In the scenario where we do purchase a Property C, D, or E, I understand that the mortgage interest incurred for that portion of the debt would be deductible as long as I calculate the correct percentage (substituting the cash value that was actually used in the equation I provided in the other thread) and include them in the correct rental property columns in Schedule E Form 1040, correct?