ADU Mortgage Interest Deduction

[tgreen18]

I have one mortgage which was used to buy our home that has an a cottage/ADU in the backyard. We rent that cottage. It is my understanding that expenses including mortgage interest and taxes should be prorated based on the square footage of the cottage / the total living space on our property (house + cottage). It's also my understanding that expenses specific to the rental do not need to be prorated. 

In the rental section of TurboTax I entered the amount of interest attributable to the rental (total interest paid on our mortgage multiplied by the aforementioned %).  Then, in the deductions & credits section I enter all the information from our 1098. The balance on our mortgage is > 750,000 so the actual deduction gets capped (as can be seen in Federal Review). 

Here's what I want to confirm:  I am separately deducting interest for the rental AND for our primary residence. This means we are deducting interest on more than $750,000 of the loan. On one hand this feels like double dipping. On the other hand, it sees reasonable in that we paid more for our house in order to have this investment rental side business and income. Can you confirm whether I'm doing this correctly?

Thank you for your insight.

[HopeS]

To avoid the chance of unintentionally double dipping and potential errors, the recommended way to enter your mortgage Interest, property tax, and other allocable expenses would be to enter them in the rental property section of TurboTax. In the rental property section under your Property Profile, indicate that you rented out part of your home.

On the page, Let Us Calculate Your Expense Deductions for You, a yes answer will allow you to enter the entire mortgage expense and TurboTax will do the math for you based on the rental % of your home. If you choose this method, then you wouldn't enter the deductible personal portion again. TurboTax would transfer the personal portion to Schedule A.

All other expenses directly related to the Rental Cottage should be deducted 100% on Schedule E. Once you complete your return, review both Schedule A and E to ensure the expense allocations are correct.

@tgreensweig 

[leeloo]

If you follow this procedure of renting out part of your home,  you will need to increase the basis of your home by the cost of the ADU.   In order to have the proper basis in the event of a sale, you will treat them both as one unit. 

@ 

tgreen18

[tgreen18]

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 

[BrittanyS]

Unfortunately, TurboTax does not support the calculation for rent of a portion of your home.  You will need to manually adjust the interest deduction amount on the Tax and Interest Deduction Worksheet for Schedule A, Form 8829 and/or the Schedule E Worksheet if you are subject to limitations. Refer to IRS Publication 936 for help if necessary.

@tgreen18