Consolidating loans on investment property with primary residence mortgage

[hindsight2019]

@Carl secured loans are not hard requirements, are they? For example, personal loans used for business can be deducted as business expenses. 

[Carl]

There is no such thing as a personal loan used for business. It's a business loan, and if the proceeds are used for business, the interest on that loan is deductible as a business expense.

At best for a personal loan, you might take out a personal loan to start a business, and those costs (including the interest paid on the loan up until the business actually opened) would be start up expenses - which are totally different from business expenses. Generally, one takes out a personal loan to start a business when the not-yet-established business would obviously not qualify for any other type of loan.

But rental property, which is reported on SCH E, is not in any way, form or fashion, anywhere like your "normal" business that is reported on SCH C. For one thing, start up expenses are flat out not allowed with SCH E rental property. Period.

Your line of thinking just doesn't cut it. Even if you used the proceeds from refinancing your primary residence to pay cash for a rental property, (which is basically what you did in this case) the loan is not secured by that rental property which was "paid in full" with the proceeds from the refi on your primary residence. In other words, the rental property itself is not "at risk" of foreclosure, should you default on the loan. Only your primary residence is at risk; and that's not business property any way you look at it.

[smarttees]

Confusing home mortgage interest deduction with the rules for tracing....info at the link below....tracing rules can be used and the rental property itself does not have to be at risk of foreclosure.

elect not to treat debt as secured by qualified home 

[NCperson]

after watching how this thread developed,  please go back to what @Critter posted as this is from publication 936 (page 4) which has been posted 3 times in this thread . This is the 'tracing' language many are referring to with the salient portions in red font. 

Choice to treat the debt as not secured by your home. You can choose to treat any debt
secured by your qualified home as not secured by the home. This treatment begins with the tax
year for which you make the choice and continues for all later tax years. You can revoke your
choice only with the consent of the IRS. You may want to treat a debt as not secured
by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest 

[Critter]

@hindsight2019 

Your CPA confirms the IRS tracing rules exactly ... see the rest of this thread. 

[hindsight2019]

I am sorry I find this language very confusing. English is not my native language. Is the answer yes, that I can follow my strategy of legally consolidating loans (without losing deduction benefit), or no? Appreciate your help.

[hindsight2019]

The above was addressed to @NCperson 

[hindsight2019]

@Carl securing of property and foreclosure is a concern for the lender. If lender A gives you a loan for property using your property as a collateral, versus lender B gives you the same loan, at the same terms w/o securing your property, how does it affect IRS? So long as you are paying interest, it is an expense out of your income. 

IRS should be happy that I have reduced my total interest and deductions. They benefit from it as much as I do. It is only the lender who wants to charge me arm and leg for rental property loses. 

what am I missing?

[NCperson · Accepted solution]

suggest at this point, as there is so much savings at stake here, spend just a tiny bit of that savings by hiring a local CPA.  That way you have 'piece of mind' that you are making the right decision for your circumstances.  I don't think an anonymous public board is going to get you to that 'piece of mind' requirement.

[Anonymous]

under reg 1.163-10t(o)(5)(i) a taxpayer may elect to treat mortgage debt as not secured by a qualified residence.  also see reg 1.163-8T

example from 10T

i) C borrows $60,000 secured by a qualified residence. C uses (within the meaning of § 1.163-8T) $20,000 of the proceeds in C's trade or business, $20,000 to purchase stock held for investment and $20,000 for personal purposes. In 1990, C pays $6,000 in interest on the debt and, under the rules of § 1.163-8T, $2,000 in interest is allocable to trade or business expenses, $2,000 to investment expenses and $2,000 to personal expenses. Assume that under paragraph (e) of this section, $2,500 of the interest is qualified residence interest and $3,500 of the interest is not qualified residence interest.

(ii) Under paragraph (e)(4)(iii) of this section, C may allocate up to $2,000 of the interest that is not qualified residence interest to any of the three categories of expenditures up to a total of $3,500 for all three categories. Therefore, for example, C may allocate $2,000 of such interest to C's trade or business and $1,500 of such interest to the purchase of stock.

[u0d4n7a0p]

@hindsight2019 

What did you finally do/figured out? Can you claim the interest in Schedule E and claim that as an expense on rental property?

[amesfans8721]

@hindsight2019 

i would like to know the outcome too please?

[Carl]

I've searched all over the IRS website for documentation concerning what I guess would e called a "mixed use" type of secured loan, and I can't find jack squat that comes anywhere close to your situation. But from what I can find in IRS Publication 536 at https://www.irs.gov/pub/irs-pdf/p936.pdf on page 3, it appears things aren't what you're expecting.

From my interpretation, whatever you claim as mortgage interest must be secured by the real estate the mortgage is for.  Furthermore, there's a limit on mortgage interest for a refinanced loan. In the case of a cash out, you can only claim the percentage of interest paid on the new loan, that is equal to the percentage of the new loan that was used to pay off the original amount owned on the original loan.

So if your mortgage balance before the refi was $50K and you refi'd for $100K, that means $50K of the new loan (50% of the new loan) was used to pay off the old mortgage. So only 50% of the interest paid on the new loan loan is deductible on SCH A for the life of the loan.

Since the remaining $50K was not used to improve the home that secured the new loan, it's not deductible at all.

The clarity you're looking for, I can't seem to find anywhere. With my current line of thinking, since that $50K you cashed out and used to pay off the rental is not secured by the rental (it's secured by the primary home you refinanced) I believe it's not deductible on SCH E, or anywhere else for that matter.

But I also interpret it that, if you had used that money to go out and "buy" a rental property, then it would be deductible on the SCH E.

Overall, I highly recommend you spend a few bucks of that cash out for professional help. Would also be nice if they could provide you a citation on the IRS website (which you could share here) that clarifies things one way or the other.

[tagteam]

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@Carl wrote:

I've searched all over the IRS website for documentation concerning what I guess would e called a "mixed use" type of secured loan, and I can't find jack squat that comes anywhere close to your situation.

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You simply had to read through this thread; the answer (posted multiple times) is right here.

[Section 1.163-10t(o)(5)(i) - which is also more or less spelled out in Publication 936]