Tracing Rules for Mortgage Interest Used to Buy Other Rental Properties

[Dave918]

Hello,

I have borrowed against rental properties that I paid cash for and used the funds to buy other rental properties (and kept records as required by the Tracing rules). For example, I borrowed against property A (which I paid cash for) to buy properties B and C (which have no mortgage). How should I show the interest reported on form 1098 on Schedule E? My hunch is that the interest on the 1098 should be split between properties B and C (based on the tracing rules) - is this correct? Would splitting the interest on properties B and C cause questions with the IRS (do they allow you to split a 1098 this way)?

Thank you in advance for your response

[leeloo]

You are correct. Please see this example taken from the link below.

• Example 3: The taxpayer wants to acquire an additional rental so she refinances one of her existing rentals to obtain the down payment.  The interest on the loan must be allocated between refinancing the existing rental loan and the portion of the debt used to acquire the new rental. 

https://www.taxcpe.com/blogs/news/tracing-rules-that-apply-for-deductibility-of-interest

[Dave918]

Thanks for your response. That makes sense as it's consistent with the tracing rules. But are you sure that reporting the interest on the 1098 from property A on the schedule E for properties B and C instead won't cause confusion/questions at the IRS? In the end it's the same amount of interest as shown on the 1098 but it does not match the property address on the 1098 (and it is split between 2 other properties).

[leeloo]

Yes, you may be questioned at some point, but as long as it is reported in full amongst the properties, it will be easy to justify.

[Dave918]

Would it be wrong to ignore the tracing rules and just report the interest against property A as the 1098 shows (even though I paid cash for property A and used the money to buy property B and C)? I would prefer to follow the tracing rules but I don't want to risk a letter from the IRS. Thank you.

[leeloo]

This is the way the IRS says to do it. You may not get a letter. It is always better to file the proper way.

[Dave918]

Thanks for your response. Should I report the interest on properties B and C as if they were on a 1098? Or is the IRS less likely to question it if I said the interest on Properties B and C was not on a 1098 (even though they were on the 1098 from property A)?

[PattiF]

Yes, you should report the mortgage interest for Properties B and C  as not reported on a 1098.

 When the IRS matches amounts on forms with returns, the total amount shown on the 1098 that the IRS received will match what you have entered for the mortgage interest on your rentals. As long as the numbers add up and match, there will not be any questions from the IRS. 

@Dave918 

[Dave918]

This is a bit confusing - you are saying that it is better to show the interest for properties B and C as NOT reported on 1098? But you are also saying that they add up the interest claimed on all the rentals and compare to 1098 (which would imply saying the interest for B and C was reported on 1098)? Please clarify thank you.

[PatriciaV · Accepted solution]

Yes, enter the interest for Schedule E on each rental property under "Other Interest," not on the page for interest reported on Form 1098. Only the property listed on the 1098 should have interest reported on the mortgage interest line.

Basically, the IRS matches the interest you report to the total interest shown on Form 1098. If you report more interest in total than is shown on all 1098's you received, this could possibly trigger an inquiry by the IRS (unlikely). A review of this sort is generally part of an audit, not the automated review of most returns.