I refinanced my home to pay off the mortgage on my rental house. Can I deduct the interest in the expense and assets part to offset the income from the rental income?

[Carl]

No. Laws changed in 2018. If you did a cash out refi, you can only claim that percentage of interest equal to the percentage of your refi that was your outstanding balance at the time of the refi. It's a SCH A deduction. What you did with the cash is irrelevant in your case. Having used it to pay off a rental means that the rental is no longer collateral on any mortgage, as you now own it free and clear.

So if at the time of refi you owed $50K on your primary residence and you refi'd for $100K, thus cashing out $50K, only 50% of your interest on that refi loan is a SCH A deduction for the life of the loan. The other 50% of the interest is not deductible anywhere. Here's a few exceptions (not all inclusive)

If you used any of the cash out money for property improvements on your primary residence, that adds to the cost basis of that property and you can include the interest for that amount as your SCH A mortgage interest deduction.

If you used any of the cash out money for property improvments on your rental, that adds to the cost basis of that rental property. You can include the interest for that amount as a SCH E mortgage interest deduction. Just be aware that tracing rules apply, and if audited you will have to produce a paper trail to prove that cash out (or any part of it you are claiming as a SCH E deduction) was actually spent on the rental property, and that the expense was in fact, a property improvement to that rental property.

[don173]

Thank You. I know this is a shot in the dark, but when you mention "tracing" I can show that the refinance money paid off the rental mortgage. The reason is, is because I refinanced with the same Mortgage Company that I had the rental Mortgage with. I did not receive any money from the refinance. Basically, I refinanced my home with NewRez and NewRez paid off the rental loan, which I said was financed through NewRez. I refinanced my primary residence to pay off the higher interest rental loan. I'm not sure if this makes a difference or not. Thank you again.

[Carl]

Here's the bottom line. The percentage of interest of the equal percentage of cash out money from the refinance of your primary residence that was used to pay off the mortgage on the rental property is just flat out not deductible anywhere on your federal return. Period.

[Opus 17]

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@Carl wrote:

Here's the bottom line. The percentage of interest of the equal percentage of cash out money from the refinance of your primary residence that was used to pay off the mortgage on the rental property is just flat out not deductible anywhere on your federal return. Period.

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There is a duplicate of this discussion here,

https://ttlc.intuit.com/community/investments-and-rental-properties/discussion/trying-to-get-clarifi...

@Carl I'm not understanding why this would not be a business expense.  We have answered other taxpayers that, for example, if they borrow from commercial property A to buy property B, the interest is an expense against property B and the tracing rules must be followed.  Or, if the taxpayer here had taken out an unsecured personal loan or credit card loan to pay off their commercial property, the interest would be a deductible business expense as long as it was traceable.  Why does it matter if the loan used to pay off the commercial property is secured by the taxpayer's residence?

(BTW, since the residence was paid off at the time of the new mortgage, and all the proceeds were used to pay off the commercial property, no part of the loan is deductible on schedule A.)

[Carl]

 I'm not understanding why this would not be a business expense.

Because the money was not earned by the business, and no business assets were used as collateral to secure the loan. The loan is secured with a personal asset - your primary residence. The fact you used the money to pay off a business asset doesn't matter. You could have used it for practically anything, and it's still not a business expense. As I said earlier, there are exceptions. But none of them apply in your specific situation. Not a single one.

I don't make the rules - congress does, the treasury department enacts them and the IRS enforces them.

[Carl]

since the residence was paid off at the time of the new mortgage, and all the proceeds were used to pay off the commercial property, no part of the loan is deductible on schedule A.)

Did I miss something? Wasn't this a refi of the primary residence? Unless I misinterpreted something, that primary residence is securing the new loan. Therefore, that percentage of the interest equal to the final balance on the original mortgage is a SCH A deduction. Wow! Wording that clearly isn't easy.

Balance left on original mortgage at the time of refi - $50,000

Refi amount - $75,000 (Making the cash out $25,000)

With those numbers, only 66.6% of the interest paid on the mortgage refi is deductible over the life of the new loan.

Now that "could" change. Let's say for example you bank that $25K and two years later you use that $25K to add on a room to the rental. (tracing rules would of course apply here big time.) At that point, the other 33.3% of the interest paid on the loan would be a SCH E deductible mortgage interest expense for the remaining life of the loan, beginning on the in service date of the property improvement to the rental.  (But things get weird when you have personal use, take the rental out of service, or sell the property.)

I sure do wish I could access the HD on my other laptop that died not that long ago. I have all my bookmarks on that one and had a bookmark for this exact, specific and explicit situation to one of the IRS pubs. Or it might have been a "tax topic" number. Can't recall. In fact, it was one of the other SUs that provided me that link. I may take a stab at removing that hard drive to an external case to see if I can access it later tonight. All the data was backed up. Just my favorites and bookmarks were not. (sigh)

[Opus 17]

@Carl , in the other thread started by the same taxpayer, they say the personal residence had no outstanding mortgage prior to the new borrowing, and that all the cash from the new borrowing was used to pay off the mortgage on the commercial property.

I'm still not understanding.  

1. If the taxpayer borrowed on a credit card to pay business expenses, the interest is a business expense even if the loan is not secured by the business, as long as the expenses are traceable.  Why would that not apply to a loan that is secured by non-business property, as long as it is traceable.

2.  Why is paying off one mortgage with another loan not a business expense?  If the interest on the old mortgage was a business expense, why not the interest on the new loan, as long as the loan proceeds are traceable. 

[don173]

Thank you for the information. Sorry about the duplicate message. I'm new to this. Correct,  I had no outstanding balance on my primary residence. I refinanced my primary residence with the same Company I had with the rental mortgage. There was no money given to me. Tracing would be easy in this case. So, just to clarify, I could use the interest on Schedule E?

[tagteam]

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@don173 wrote:

....Tracing would be easy in this case. So, just to clarify, I could use the interest on Schedule E?

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I answered in the other thread you started and I believe you can do so. I now agree with @Opus 17.

As mentioned by @Anonymous in the other thread, you can elect to treat the debt as not being secured by your primary residence and, since it is being used for a business purpose (i.e., your rental), you should be able to deduct the interest on Schedule E.

Also, I was not aware that your primary residence had no outstanding balance (you owned it free and clear) so you would not be able to deduct the interest as qualified debt on your primary home on Schedule A, regardless, unless you used the proceeds to improve your home.

[Carl]

@Opus 17

The word "RE"finance threw me off a bit.

I had no outstanding balance on my primary residence. I refinanced my primary residence

Actually, you didn't "re"finance anthing.  You financed your primary residence through the same company that held the mortgage on the rental. (Being the same company doesn't matter.)

Per IRS Publication 936:

The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes.

page 4, column 1.

https://www.irs.gov/pub/irs-pdf/p936.pdf

You'll read more there too, and see that all of the loan interest is a SCH A deduction. Seems to be "grey" on that since the loan was not used to purchase a "new" home or anything. But I'm looking at the first two columns on page 3 under Secured Debt. The debt is 100% secured by the primary residence only. The rental is not "secured" by anything because there is no debt owed on the rental.

[Opus 17]

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@Carl wrote:

@Opus 17

The word "RE"finance threw me off a bit.

I had no outstanding balance on my primary residence. I refinanced my primary residence

Actually, you didn't "re"finance anthing.  You financed your primary residence through the same company that held the mortgage on the rental. (Being the same company doesn't matter.)

Per IRS Publication 936:

The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes.

page 4, column 1.

https://www.irs.gov/pub/irs-pdf/p936.pdf

You'll read more there too, and see that all of the loan interest is a SCH A deduction. Seems to be "grey" on that since the loan was not used to purchase a "new" home or anything. But I'm looking at the first two columns on page 3 under Secured Debt. The debt is 100% secured by the primary residence only. The rental is not "secured" by anything because there is no debt owed on the rental.

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This mortgage secured by the residence is never deductible on schedule A because it is not acquisition debt for the residence, it is equity debt and interest on equity debt is not deductible.

We are arguing that the interest expense can be a business expense using the tracing rule, even though the loan is not secured by the business property. 

We may have to agree to disagree, and recommend the taxpayer discuss the situation with a qualified accountant in their area. 

[Carl]

I've read through pub 936 and can't find anything that would make it a SCH E deduction beyond the tax year of the payoff. I do agree that it's not a SCH A deduction since it's not acquisition debt though. (the pub clarified that quite well) Seems to be treated the same as a HELOC where the money was not used to maintain or improve the property that secured it. (or any other property for that matter.)

Now it does "appear" that any amount of the final payoff amount that was interest would be a SCH E deduction. So for example, if the payoff amount on the rental was $100,000 and say, $7000 of that payoff was the final interest payment on that loan, then that interest, and only that interest amount would be a SCH E deduction. After that, no more interest can be deducted on the primary residence loan anywhere on the tax return.

Had the money been used to acquire, maintain value in, or improve the rental property, then it could be a SCH E deduction. But the money wasn't used for any of that. It was used to "pay off" the rental mortgage.

Seems it would have been better to refi the rental and pay off the primary residence. Then you would have at least part of the interest deductible on SCH E if it was a "true" refi with cash out.

I have a neighbor a few houses down from me that's a CPA and runs his own H&RB franchise. He's out of town until the weekend. Hopefully I will remember and present this to him after he gets home and has time to settle back into things around here.  But based on what I know now and my interpretation of 936, the interest on the loan isn't deductible on SCH E or SCH A.

I'm going through 936 again. This time I'm checking anything that pub references that might be related to this specific situation.

[tagteam]

No need to wait; Treas. Reg. Sec. 1.163-10T(o)(5)(i), as mentioned by @Anonymous in the other thread, is relevant and, most likely applicable here. 

In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

Read the balance of @Anonymous's reproduction of the section at the link below.

Solved: Trying to get clarification. I refinanced my home ... (intuit.com)

[tagteam]

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@Carl wrote:

I've read through pub 936 and can't find anything that would make it a SCH E deduction beyond the tax year of the payoff.

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You must have missed the following paragraph (emphasis added):

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.