I recently refinanced my primary residence and purchased an investment property. Initially, I was planning to cash-out my primary residence through refinance and use the money to make a down payment for the rental house. However, the refinance took more than 5 months to close, which is 3 weeks after I closed my rental purchase. When I do my tax return next year, can I still claim the interest and closing cost from the refinance as the expense for my investment property?
If the answer is yes, how much interest can I claim as the expense of investment? My primary house before refinance had a balance of 90K, I took out 65K and the new balance after refinance is 162K. The down payment for the investment property is only 40K. Since I cashed 65K I am planning to use the 25K to purchase another investment in the near future. If you happen to have any citation from the IRS it would be great! Thank you for your help in advance!
However, the refinance took more than 5 months to close, which is 3 weeks after I closed my rental purchase.
That indicates to me that not one single penny of the cash out was used to purchase the rental property. Therefore nothing is deductible against the rental. But maybe there's something about the transaction you're not telling us?
can I still claim the interest and closing cost from the refinance as the expense for my investment property?
Based solely in the information provided, the unfortunate answer is no. Like I said, maybe there are some details you left out?
My primary house before refinance had a balance of 90K, I took out 65K and the new balance after refinance is 162K.
Since your balance before refinance was 90K, that's 55% of the refi. Therefore 55% of your interest is a SCH A itemized deduction against the primary residence, every year until paid off.
Since I cashed 65K I am planning to use the 25K to purchase another investment in the near future.
That $25K would be 6.5% of the total refi amount. Therefore 6.5% of the interest paid every year would be a SCH E deduction.
Thank you so much for your detailed response @Carl
I started the refinance in June 2020 and hoping to use the cash-out money as a downpayment for an investment that closes in late October 2020. I was confident that the refinance would be done before the purchase but I was wrong. The refinance was not done until November 2020. I end up using my savings to make the downpayment for the purchase. However, I started the refinance 3 months earlier than the purchase and my intention is to use the cash-out refinance for this investment. Do you think I may still able to deduct the interest and fees against the rental?
If the answer is no, I am still planning to use the money to buy more rental. If I use 40K in December 2020, and 25K in March next year, how should I do the calculation for tax-deductible against the rental income? I am not sure how to prove it that I use the 65K cash-out money for investment purpose and how to handle the timing when calculating the deductible taxes. Thank you so much for your time!!
I see you're trying to create loopholes where they don't exist. 🙂 You're not the first, and won't be the last.
When you started the refi of your primary residence is irrelevant. Doesn't matter if it took you 5 minutes, 5 months or 5 years to close on that refi either. All that matters is the closing date, and not much else.
Fact: You did not have any control or possession of the cash out money prior to closing on the rental property. Therefore there is no possible way you could have used that money towards the purchase of the rental. Period. End of story.
Opinion: If you claim the use of any of that money towards the purchase of the rental you closed on, before you closed on the refi, if/when the IRS audits you and catches it, it will be costly for you. It is not at all uncommon for what is referred to as a "paper audit" to occur 4 or more years down the road. (I've seen some audited as far back as 9-10 years, and a small few more than that.) If/when that happens to you, then you'll owe back taxes, fines, penalties and late fees for each and every tax year you claimed that interest. My advice is, don't do it.Rest assured that if the IRS comes knocking on this, you will lose the argument.
FACT: if you plan to purchase another rental using some of that refi money, don't wait to long. The IRS expects any reinvestment of a cash out to be done in a "reasonable" time frame.
OPINION: I've never been able to find any definition of what the IRS considers "reasonable". I would "expect" within 6 months to be reasonable. But the IRS may expect differently for all we know.
Thank you so much for your response! It is so knowledgeable and informative! I assure you I am not trying to avoid taxability. This is my first cash-out refinance and I have little knowledge about interest and tax-deductible. I used to think it might be a "grace period" since the 2 loans happened at the same time. My refinancing bank did a poor job and totally changed my financial goal. I didn't expect it took 5 months to close a loan. But it is what it is. I truly appreciate your helpful advice about not claiming it against the purchase loan at this time. It sounds pretty dangerous and I am not risking myself in that scenario. Thank you for the notice again.
I am actively looking to buy another property for investment. The market right now is pretty calm since most families want to stay through the holidays. But I do expect more supply will be available after Christmas. It just hard to define what is "reasonable". And hope my plan is reasonable. Maybe before March is reasonable? Wish I could find a rule from IRS, black and white, I am so afraid of uncertainty. But now makes it complicated since it may cross the year. If I pay $5,000 interest for my primary resident loan in 2021, and I know I cashed 65K in 2020 and $3,000 closing cost. If I use the 65K to buy a house for rental in Feb 2021, can I still claim 55% of the interest in 2021 as cost against this new rental? Should I calculate the cost proportionally, like $5,000x55%x10/12 since it will be in February? How would that affect my 2020 return and how should I claim the cost in 2021 for a refinance in 2020...? I am sorry I have asked you so many questions!!!
I'm having difficulty interpreting your last post. But I "think" I got it now.
For the refi since 55% of the refi is to pay of the original loan, only 55% of the interest can be claimed as a SCH A deduction. The other 45% of interest is just flat out not deductible. Doesn't matter if you figure it at 55%/45% per year, or 55%/45% per month.
Now lets pick of figure of say, 10%. That would be $16,200 of your cash out funds. Now lets say you put that as a down payment on a rental and you close on that rental on Apr 1st,
At the end of 2021 the 1098 you receive from the refi lender shows you paid $10,000 total in interest. 55% of that, or $5,500 is a SCH A itemized deduction for the entire year. 10% of that, or $1,000 is deductible on the SCH E for the entire year. However, you didn't close on the rental property until Apr 1st. So you can't deduct that $1,000 for the entire year. Apr thru Dec is only 9 months. Since you closed on the rental in April that means you can claim 9/12 of that So $1,000 devided by 12 is $83.33 per month. Multipy $83.33 by 9 and you get $749.97. That's all you can claim on the SCH E in that first year you close on the rental. Every year after that, you can claim the full 10% which is $1,000.
As far as that non-existant "reasonable" definition, my suggestion would be to "NEVER" touch that money in savings intended for the down payment. *NOT* *EVER* until you are ready to withdraw the required amount on *the* *day* you make the down payment. That way, I don't see any problem with you showing the "flow" of the money directly from the cashout, into the savings account, and then directly to the down payment on the next rental property.
When it comes to doing what you're planning here, being able to trace the flow of the money is "EVERYTHING". Break that trace in any way, then if the IRS questions it, you will probably lose.
Finally, as a disclaimer, understand that I am not a TurboTax Employee or tax expert by any stretch of the imagination. I do own three rental properties and my primary residence and have 30 plus years experience as a landlord. Over that time I've done my share of mortgages and refi's however. Do be aware that since the 2018 tax law changes I've not mortgaged or refi'd anything. Primarily because of the change in the tax law which says you can only deduct interest based on the "original" loan balance prior to the refi. I am in the process of doing a refi on my primary residence right now, but I"m not cashing out. I just want to refi the outstanding balance because the lower interest rate will lower my payment by just over $300 a month.
Thank you again Carl! I think I got it!! But keeping the $65K check without putting in my saving account for months seems hard to do. IRS is not making it reasonable...I might just end up to forget about the benefit and not claiming it...
Oh by the way, do you know if IRS can answer my question? Do they have a department to answer tax payer's question? If not, do you recommend any real estate CPA? I am a new landlord and lack experience when it comes to tax. You helped me a lot in this scenario! But I may have more questions to ask in the future. If you know any good CPA or IRS department would you mind referring? Thanks a million!!!
If you don't mind being on hold for a really long time, and pushing buttons that may never get you to a human, the IRS number is 1-800-TAX-1040 (800-829-1040). Good luck getting a human.
One IRS publication that does a "fairly" good job of covering the tax aspects of residential rental real estate is IRS Publication 527 at https://www.irs.gov/pub/irs-pdf/p527.pdf
Most questions relating to rentals I can answer. But keep in mind that laws differ state to state. I'm in FL which doesn't tax personal income. So I don't have to deal with state taxes on this. Whereas in a state such as Hawaii, you're guaranteed that you "WILL" Pay a state tax on every single penny of rental income. It's referred to as the GET tax, or General Excise Tax. Presently, the state tax rate for the GET is 4%. of the *GROSS* rental income. Property owners can add to that any county surcharges that may be imposed. Now you know why rents are so sky high in Hawaii.
I have found in my limited experience with legal professionals on this, that a lawyer that specializes in probate, wills and estates seem to be the most knowledgeable. I have a lawyer on retainer and probate, wills and estates is all he does. A fair number of his "clients" who pass away are business and rental property owners.
He's had to deal with evicting tenants for not paying rent when they thought they could just stop paying when the landlord passed away. Also, handles the transfer of ownership per the landlord's will, or per state law if there is no will.
For most such scenarios he's able to handle the taxes too. While he can help with tax planning he doesn't claim to be a tax expert and usually refers to other lawyers or CPA's that he knows is more knowledgeable on the tax aspects of a given situation.
I am a new landlord and lack experience
We all lacked experience when we started out. While we may have learned the ins and outs of remtal property management before committing to that first purchase, not all of us got educated on the tax front prior to diving in. Here's a synopsis of how it most commonly works. Especially if there's a mortgage on the property.
Understand that rental income is passive. Likewise rental expenses are passive. You can deduct your rental expenses "only" from the passive rental income, and that's it for the most part.
From year one, your rental property will operate at a loss "ON PAPER" at tax time, every year. When you add up the expenses of mortgage interest, property insurance and property taxes and add them to the depreciation you are required to take by law each year, those deductions alone will almost always exceed your total rental income for the tax year. Add to that the other rental expenses you're allowed to deduct (maintenance, repairs, etc.) and you're practically guaranteed to operate your rental business at a loss each and every year.
Your losses will commonly exceed your rental income each year. Once your deductible rental expenses get your taxable rental income to zero (and it will) that's it. You can't deduct any more. The excess loss just gets carried over to the next year where you can deduct it "if" you have the rental income to deduct it from. Most likely, you won't have the rental income to deduct it from.
So with each and every passing year your carry over losses will continue to grow. You can't "realize" those losses until the tax year you sell the property. Only then can you deduct your carry over rental losses from "other" ordinary income.
Additionally, in the tax year you sell you are required to recapture all depreciation taken on the property and pay taxes on it in that year of recapture. Depending on your AGI in the year you sell it, your recaptured depreciation will be taxed anywhere from 0% to a maximum of 25%. So even if your AGI puts you in a higher tax bracket the recaptured depreciation will be taxed at a maximum of 25%, assuming tax laws on this don't change in the future.
If you don't mind being on hold for a really long time, and pushing buttons that may never get you to a human, the IRS number is 1-800-TAX-1040 (800-829-1040). Good luck getting a human.
Oh I remember now. I have called this number for another issue and it took 2 hours for a human. And she just asked me to read the publication.
Most questions relating to rentals I can answer.
Thank you so much! Your abundant experience is definitely a huge asset to people like me. If I bother you please let me know! I just afraid to ask you too much and use your time too much. Regarding the CPA, you made a good point. I am in AR where income is heavily taxed and I may ask around for a local CPA first. Do you know how much do they usually charge? I know it is different and so many moving parts. Just want an idea about the consulting cost.
Additionally, in the tax year you sell you are required to recapture all depreciation taken on the property and pay taxes on it in that year of recapture.
This brings my deep concerns about the depreciation. I am always afraid to claim depreciation on my tax return. Although I did, I am so worried when I sell my property it will come back and bite me. It just like an accumulated risk to me. I can't help to think about 10 years from now the majority of my houses are depreciated (I do 15 years loan) and the value of the houses goes up over time. When I quit being a landlord(not that I would, just saying) and sell these houses, I will suddenly have tens of thousands of income to pay taxes on.
About the cash-out money, I thought about it since you told me about the traceability is "EVERYTHING". What if I open a new saving/checking account and put the money there. I won't use that account to do anything except buying houses in the future. Do you think that's a good idea?
I may ask around for a local CPA first. Do you know how much do they usually charge?
Last time I paid a CPA to do my taxes was back in 2003 and it was $120. I'd expect it to be at least triple that now. You may find it cheaper to sign up for TurboTax Live for your 2020 taxes. That gives you phone access to a certified CPA that, while they won't do your taxes for you, it enables you to do things like have your return reviewed by a CPA prior to filing it. There's also the ability for live online video chat sessions with a CPA and if you want, you can even give them access to the tax return you're working on. Just understand that TurboTax is a "self-prepared" program. So a CPA is not going to complete and/or sign the "Paid Preparer Use Only" section of the 1040.You can check out what TurboTax Live gets you at https://turbotax.intuit.com/personal-taxes/online/live/
I am always afraid to claim depreciation on my tax return.
You state that like you think you have a choice. You don't have a choice. You are required by federal law to claim depreciation. If you don't claim it, then in the year of sale you are required to recapture the depreciation you "should" have taken, and still pay taxes on it.
I am so worried when I sell my property it will come back and bite me
It will. No doubt about that. But it may not be as big a bite as you may think. Here's a rough synopsis of how it works.
You purchase the property for $100,000 and rent it out for 10 years. At the end of 10 years you have taken lets say, $25,000 in depreciation. You'll also got a fair amount of those other carry over losses. Now lets say for the sake of argument that your other carry over losses are $25,000.
You sell the property for $200,000 after ten years. The original cost basis on the property was the $100,000 you paid for it. Now reduce that cost basis by the $25K of depreciation taken and that makes your adjusted cost basis $75,000. That means you have a $125K gain.
Now subtract your other carry over losses of $25K from that gain, and now you have a $100K taxable gain.
I do 15 years loan
That could be a good thing. Once you pay off the mortgage after 15 years (assuming you keep the property that long) that means there's not more interest deduction. So if (and that's a really big *if*) the property starts showing taxable income at tax filing time, all those prior year carry over losses will be used to reduce that taxable rental income. Probably reduce it to zero the first few years.
So if you reach retirement age and retire in say, 2035, you sell the property for a $100K taxable gain, take your minimum required distribution from your retirement account, and you're taxes won't be that much different than they were the year prior when you were working.
What if I open a new saving/checking account and put the money there.
Not a bad idea. But it's really not necessary. If you're planing to put say, $15K down payment on your next purchase, just make sure you're balance never goes below that until the day you make that down payment.
There's quite a bit of info in the link I sent you via PM. I suggest you take a break and read it through. But like I said, my writing skills are not all that great and it may seem haphazardly organized. That's because it's a first draft, and it "is" haphazardly organized. 🙂
Thank you Carl! Let me read your notes first. And I REALLY APPRECIATE your help!!!
P.S. It is funny when you said that "You state that like you think you have a choice." I did think I have a choice! It just every time you respond I can learn so many things! Thank you again!!