Renting ADU on primary residence

[Carl]

Say I buy a house with an attached ADU and finance it with 1 million loan and say ADU takes 25% of sqfootage and primary residence ( "main home" ) takes 75% of sqfootage.

Then 25% of the mortgage interest paid is deducted on SCH E. Period. End of story. Nothing further to discuss.

The remaining is a SCH A itemized deduction subject to the limits as set forth in the TCJA of 2018. If the remaining 75% of the mortgage balance exceeds $750,000, then the SCH A mortgage interest will be limited until such time that remaining 75% gets to $750,000 or lower.

[u0d4n7a0p]

@Carl We are on the same page with regard to how interest is split. My question is with regard to accounting of principal payment (which then would decide the interest calculation for the next year for each of main house and ADU),

Here are repayment ordering rules from 1.163-8T

B. REPAYMENT ORDERING RULES.
We generally know whether a particular debt has been repaid, but when the debt
has been used for multiple purposes, we need to know which portion has been
repaid. When a debt has multiple characters, the regs provide the order of
repayment. General order (for a mixed purpose loan). Under Treas. Reg. 1.163-
8T(d)(1), debt is treated as repaid in this order:

a) First Allocated First Paid – If there is more than one
expenditure in the same category, they are treated as repaid in the
same order in which they were allocated.
b) Qualified Residence interest is “personal” interest under the
-8T regs. So presumably rule b) applies to allocate repayment
between personal and residence interest. However Pub. 936 has a
mini set of ordering rules:

( The publication needs to be updated. Home equity debt should be
replaced with Personal. )

1- Personal
2- Investment or passive activity
3- Rental passive activity w/ active participation
4- Former passive activity
5- Trade or business

[Carl]

My question is with regard to accounting of principal payment

I thought you were clear on that. Using the numbers above, you'll have to manually figure the allocation each year, until the principle amount paid off, equals the percentage rented.

So with a $1M loan and 25% rented, the rental portion is not paid off until the principle is down to  a $750,000 outstanding balance owed.

[u0d4n7a0p]

@Carl 

1. You mean that till all of 750K debt allocated for the "main house" (primary residence) is paid off,  I don't begin paying off the 250K debt allocated for the rental ADU. Correct?

2. This means that, after the first year, every year the allocation of interest for the "main house" and ADU has to happen based on the principal balance calculated following the rule stated in 1 above.

My question boils down  to  - is the interest paid  on principal  borrowed for primary home a personal interest. Instead of 750K and 250 debt for primary and ADU, assume 900K and 300K. I start paying off 300K only after the 900K is paid off in entirety. Is that right?

[Carl]

I note your numbers are different that the $1M you originally stated. So your secured loan amount is $1.2M

I start paying off 300K only after the 900K is paid off in entirety. Is that right?

If that were so, then you would not be able to claim "any" of the interest on SCH E until you paid off the 900K.

Your percentage allocated to the rental will change yearly, based on the outstanding balance and amount of interest paid. The math used by the IRS is a bit complex to me and I don't fully "get it" myself.

[u0d4n7a0p]

Are you saying that as per rules, the debt which gets paid off first is the debt allocated to the rental?

[Carl]

Are you saying that as per rules, the debt which gets paid off first is the debt allocated to the rental?

Again, I don't fully understand the rules. But as I see it, nothing gets "paid off first". You are allocating a percentage to the rental every year. But that percentage will change every year based on factors such as outstanding loan balance at the beginning of each year, and total interest paid on the loan each year.

I would expect the outstanding balance to decrease with each passing year, and since the amount of each payment allocated to the interest will get lower as the outstanding balance drops, the percentage of interest allocated to each property will also change.

There are others in this forum that are more familiar with this than I am, and I'm hoping they'll see this thread and jump in. I'm not sure, but I think @Rick19744 is better versed in the math than I am.

[Rick19744]

As you can see from reading the temporary regulation, there are many facets to these rules, and your facts are limited.

Based on the limited facts:

• The general rule of the regulation (c) is that the interest expense is allocated based on how the debt proceeds are used.
• In your example (the original facts of 75/25), it appears that the interest expense should be allocated in this proportion.
• This same regulation (d) provides the rules when there is debt repayment "If, at the time any portion of a debt is repaid, such debt is allocated to more than one expenditure, the debt is treated for purposes of this section as repaid in the following order:..."
  • The debt repayment is allocated to the personal expenditures first.  I would argue that the residence is a personal expenditure.
  • As a result, you would need to reduce the principal of the apportioned debt related to the residence.
  • This appears to be taxpayer favorable.
• Based on the above, you would then need to update your interest allocation percentage after reducing the personal debt component.  Once again based on the original facts (75/25), and assuming no principal reductions before this, the revised personal debt component would be $720,000 (original 750,000 less the 30,000 principal repayment).

[u0d4n7a0p]

Hi,

It was my understading too that in my example  ( 1 million debt , 750K for primary home - main unnit - which is 750 sqft and 250K for 250sqft ADU), if 30K is the amount of principal paid in the year entire 30K is adjusted towards the 750K debt on the primary. 

However, why do you think debt ratio ( percentage of debt for each unit) has to be recalculated every year? Debt allocation happens when you actually borrow. Or rather strictly speaking, debt is (re)allocated when you change the usage of 250sqft from your primary to ADU rental. Given that the allocation of sqfootage for rental ADU or any of that isn't changing, why does one need to reallocate percentage of debt for each unit every year?
@Rick19744 


PS : 30K in the original example getting adjusted towards 750K debt on primary makes sense to me. Say I had two separate loans, one on primary and other on a rental, given that rental interest is totally deductible against rental ncome and that primary mortgage is not tax deductible for interest accrued on amount above 750K, I would first pay of primary  (for sure till outstanding principal falls to 750K)

[Rick19744]

I didn't say it had to be adjusted / revised each year.

It should only be adjusted when you make a significant principal payment towards the debt.  Other than that, it will remain constant.

Let's use a "worst" case scenario and you paid $750,000 in principal.  At this point in time, the personal portion of the debt has all been paid off and all interest expense is attributable to the ADU; it is no longer 75/25.

So the same analogy when you paid the $30,000, while this is certainly not significant, over time this could make a difference depending on principal payments made.

So in this case, you paid $30,000 and the split is $720,000 / $250,000 = $970,000 = 74/26 at this point.

If you paid down another $100,000, the split is now $620,000 / $250,000 = $870,000 = 71/29 percentage.

[u0d4n7a0p]

@Rick19744 Niw I see what you are saying. in the first year  the interest allocated for the primary home is

(total interest charged by the bank in the full year  * 750 )/1000. Assuming that total principal that got paid in the first year  year is is 30K,  - the said amount  in the second year would be (total interest charged by the bank in the full year  * 720 )/1000 ... and so on.

Did I get that right?

I too would calculate it this way. But honestly, there is some principal getting paid every month. I don't know whether IRS expects you to calculate this every month. 

[u0d4n7a0p]

Correction : interets in the second year for primary would be (interest paid that year * 720)/970 

[Rick19744]

Once again, you ONLY need to update the ratio if you pay down principal only.

Making regular monthly payments does not affect the ratio since both are being reduced proportionally.

[u0d4n7a0p]

@Rick19744 , my understanding is that even the regular monthly payment first pay off the debt on primary. Only when entire 750K on primary is paid off (regardless of whether you do it by just the regular monthly payments or do lump sum payments every now and then in addition to regular monthly payments), you start paying the debt on ADU. 

I didn't see any thing in debt repayment ordering rule which said that it applies only for payments which are __not__ the regular monthly payments.

[Rick19744]

In retrospect, and reading the temporary regulations, I believe this would be a fair interpretation.

The issue at hand, and one that can be rectified in the future, is to have separate loans for each purpose; which based on the limited facts is not the current facts.