Secure a loan from primary to pay off rental mortgage. can interest from the primary still be deducted as rental expense?

[HL1]

secure a mortgage to purchase a rental property.  later secure a mortgage from primary residence to pay off the rental mortgage since the interest rate on primary is lower. Can interest from the primary still be deducted as rental expense?

[RichardK]

Yes, the interest allocated to the rental portion of the loan can be deducted from rental income. Click here to see IRS publication 535, section 4 Interest, which states "In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific use." This is referred to as the Interest Tracing Rules.

[HL1]

Is there an option to claim the mortgage interest secured by primary home to pay off rental on schedule A? (income is too high to cover rental loss) and switch back to rental expenses next year?

[Marcia M]

I would disagree. The interest would not be deductible as rental interest. Please see the special caution !!! box in Pub 535 that states "P.L. 115-97 sec. 11043 limited the deduction for mortgage interest paid on home equity loans and line of credit. For more information, see Pub. 936."

[Carl]

@Marcia M that note applies to HELOCs and other equity loans. This was a refi.

However, I can't find anything to substantiate @RichardK 's reference to "rental portion of the loan"  The rental property is owned free and clear now and was not used to secure the loan. Additionally, funds from the loan (as far as I can tell) were not used to improve the rental property either. Based on my understanding of the tracing rules, the mortgage interest can not be claimed on the SCH E. It's a SCH A deduction subject to the SALT limits.

[Gpriddle]

Hmmm . . . I'm reading the tracing rules in the TaxBook, page 4-14, and other than the need to allocate the use of the interest, I don't see any reason why he cannot deduct the interest on Schedule E, as long as he used it for the rental.  Had the Cx used the monies towards his primary home, it would be deductible on Schedule A.  My understanding is that Sched A deductions must be secured by the home and used for the home, but w/regard to Sched E, I'm not sure why s/o who for example took out a cash or credit card loan and used it towards the rental could not deduct the interest on Sched E.  This seems kind of like that.  Businesses can take out all kinds of loans and write off the interest as long as the expense is for the business.  

Here's what TaxBook says, as of 3/11/23.  

Interest Tracing Rules (Allocation of Interest)The rules for deducting interest vary depending on whether the loan proceeds are used for business, personal, or investment activities. If loan proceeds are used for more than one type of expense, the interest must be allocated based on the use of the loan’s proceeds.Interest tracing rules do not apply to pre-October 14, 1987, home mortgage interest, which is deductible regardless of how loan proceeds are used. See Home Mortgage Interest, page 4-10, and Elec-tion to Treat Mortgage Interest as Not Secured by the Home, page 4-11.Interest categories. Allocate interest expense to the following categories.

•Nonpassive trade or business activity interest.

•Passive trade or business activity interest.

•Investment interest.

•Portfolio interest.

•Personal interest

[Carl]

Is there an option to claim the mortgage interest secured by primary home to pay off rental on schedule A?

No. Because you did not use the proceeds to "buy, build or improve your main home" which is the one used to secure the loan.

(income is too high to cover rental loss) and switch back to rental expenses next year?

For starters, you can't arbitrarily switch back and forth. If you claim it as a SCH A itemized deduction, then it may not help anything if the total of your SCH A deductions does not exceed your standard deduction. Additionally, some of those deductions are limited by SALT anyway.

For rental property, it is most common for rental property to operate at a loss each and every year, on paper at tax filing time. Once your rental expenses gets your taxable rental income to zero, any excess loss is just carried forward to the next year. Then the next year you can use/claim the loss provided you have the rental income to deduct it from. (more than likely, you won't)

Rental losses just continue to carry forward and grow. You can't realize those losses until the tax year you sell the property. When you sell, all of your carry forward suspended losses are released, and you can claim them against any gain realized on the sale, as well as any other ordinary income you may have.

Now there is a provision in the Tax Cuts & Jobs Act of 2018 that allows you to deduct up to a maximum of $25K  of excess passive losses against other ordinary income. So it's perfectly possible for one to not have any carry overs. But in your case, if your income is to high that won't be allowed. It just gets carried forward.

[Carl]

Is there an option to claim the mortgage interest secured by primary home to pay off rental on schedule A?

[Carl]

No. Because you did not use the proceeds to "buy, build or improve your main home" which is the one used to secure the loan.

[Carl]

(income is too high to cover rental loss) and switch back to rental expenses next year?

[Carl]

For starters, you can't arbitrarily switch back and forth. If you claim it as a SCH A itemized deduction, then it may not help anything if the total of your SCH A deductions does not exceed your standard deduction. Additionally, some of those deductions are limited by SALT anyway.

[Carl]

For rental property, it is most common for rental property to operate at a loss each and every year, on paper at tax filing time. Once your rental expenses gets your taxable rental income to zero, any excess loss is just carried forward to the next year. Then the next year you can use/claim the loss provided you have the rental income to deduct it from. (more than likely, you won't)

[Carl]

Rental losses just continue to carry forward and grow. You can't realize those losses until the tax year you sell the property. When you sell, all of your carry forward suspended losses are released, and you can claim them against any gain realized on the sale, as well as any other ordinary income you may have.

[Carl]

Now there is a provision in the Tax Cuts & Jobs Act of 2018 that allows you to deduct up to a maximum of $25K  of excess passive losses against other ordinary income. So it's perfectly possible for one to not have any carry overs. But in your case, if your income is to high that won't be allowed. It just gets carried forward.