Does paying rental mortgage principal with investment cash maintain its classification for investment interest expense?

[AS242]

We've rental property here in MT which we refinanced to get some cash out to buy the land next door to us. We got $70K from the refinance and, while it is cash, the interest we pay is considered as an investment expense. We paid $30K for the down-payment on the land so the interest associated with the $30K (plus the loan on the bare land) are considered as an investment expense (with the bare land as the investment). So now I have $40K and want to know if various ways of spending it would preserve the classification of the interest paid on the $40K portion of the loan as an investment expense. I know that generally I cannot deduct this interest payment, but I can offset any future investment income that might occur. Further, paying personal expenses essentially disqualifies the corresponding interest paid as an investment expense since the money was not spent for investment purposes. So, options (questions) are:

1. Buy more investment property. This is straight-forward and should preserve the interest payments as being an investment expense.
2. Pay down the existing loan principal on any of the investment properties (both bare land and rental properties) we have. This seems to me to be similar to buying investment property in that the funds are being used to decrease the principal which is associated with the loan on the property. I am investing in the property, essentially.
3. Pay normal monthly loan payments on the investment properties from the $40K but using the $40K only for the principal part of the monthly payment while using personal funds for the interest portion of the payment. I understand that paying interest payments with the investment cash probably is not allowed to maintain the treatment of its interest as an investment expense, but that is a guess. Seems that paying both principal and interest from the $40K might confuse things, but tax law is confusing, right? This option is essentially the same as #2 above, but done monthly instead of all at once.

That's my question. I hope I was clear but if not feel free to ask clarifying questions. While the advantage of keeping the interest classified as an investment expense is not great, it is better than not.

[soultax09]

The first deal is a no brainer and the others will work but you know you need to have investment income, right, because if you don't you can't deduct any investment interest.

[AS242]

Yes, of course. Dividends and stock sales at times can be used. I understand that I need investment income to be offset by that investment expense, but having an investment expense will allow that future offset.

So paying the principal of investment loans with investment cash preserves the investment expense characteristic of the corresponding interest? It was not clear in IRS documents, do you happen to have references to help me justify this approach?

Thanks for your help with this.

[Anonymous]

look at irc reg 1.163-8T.  this is the tracing rule for determining where and if you can deduct interest on the borrowings.  specifically look a  the example under (c)(1) and (d)(1)

https://www.law.cornell.edu/cfr/text/26/1.163-8T    

also see irc sec 163

did find something an example

my version 

joe borrows some money.     (the actual example does not state whether or not the loan is secured).       uses it to buy real property.    uses 1/3 as personal residence and 2/3 as rental property.   first all principal payments and interest are allocated to his portion until it is paid off.  after the 1/3 is paid off the remaining payments are allocated to the rental property. 

[AS242]

Thank you for the references. From the references, for the investment land it is clear that I can retain the investment expense characterization of the interest on the investment cash. The aspect of passive activity from my rental properties seems to imply that I cannot use the investment cash to pay the mortgage principal and retain the investment expense characterization of the interest on the investment cash. The treatment of passive activity income seems to change how the loan payments are characterized, but I suspect I'm not understanding things.

Does making the payments of principal using investment cash on my rental properties retain the investment expense characterization of the interest on the investment cash?

Thank you, again, for your help in the understanding of this issue.