Renting ADU on primary residence

[u0d4n7a0p]

@Rick19744 , temporary regulations are termed temporary for the sake of it. My understanding is that they are there from early 90s if not late 80s. 

Typically, your investment properties are smaller investments compared to how much you have committed to your primary home. Thus, your downpayment in primary home is significant compared to what you have put as downpayment for investment properties. Add. to it the fact that rental property generates taxable income, a reasonable person would want pay off his primary home faster than his rental.

Granted that if these are two separate loans, you need o pay bare minimum to both every month anyway. But that's where the way IRS looks at the loan comes into picture. IRS doesn't care what your lender is advertising the loan to be. IRS just cares how you are using that loan. Say, you do HELOC  on primary and use it for renovating the primary (and say you are still below 750K after HELOC), you can deduct the interest in itemized deduction as mortgage interest. If I you use the same money to buy car, you can't deduct the interest. You use the money for downpayment of rental property, you can deduct interest on HELOC portion from your rental income from the property.

[u0d4n7a0p]

@Rick19744 @Carl do you guys know whetehr turbotax lets you do all these calculations which are not typical?

[u0d4n7a0p]

Say,  1 million is what I borrow and 75% is self occupied area and 25% is occupied by ADU (area which is rented for residential purpose), allocating 75% debt to self occupied primary and rest to ADU is straightforward.

However, is that a must? As in, say 1.2 million is the price of the entire home and  200K is down payment. It is clear that self occupied primary  area price is 900K and that of the ADU is 300K. Now, do I have an obligation to split my down payment too in the ratio 75:25?  If I consider entire downpayment towards my primary, then loan on primary is 700K and that on ADU is 300K.  Please ignore whether this is more/less tax beneficial that splitting the downpayment in the ratio 75:25.

Comments from you would be really helpful. 

[u0d4n7a0p]

@Carl 

[Carl]

Your down payment doesn't figure into this. Your cost basis in the property it 1.2M weather you put $1 down, or one million down. There is no "splitting the down payment". You split the cost basis with 25% allocated to the 25% of the space  that is exclusive to the renter. In your case, it's an entirely different structure that constitutes 25% of your cost 1.2M cost basis.

[u0d4n7a0p]

@Carl 

My question is about debt allocation under 1.163-8T. Yes 1.2 is the cost basis and 25% is the ADU which is rented out. If loan amount is 1 million, can 300K be debt be allocated to the 25% ADU and 700K be allocated to the portion which is primary residence? If that is allowed and if I do that what it effectively means that I am saying whole of downpayment was towards the cost of the portion which is  primary residence and down payment for the rental ADU portion is 0. 

[Carl]

Again, the down payment has nothing to do with this, in any way, shape, form or fashion. Your debt is 1.2M. Period. Perhaps you incorrectly think that your down payment is some sort of separate expense that you can claim as some kind of rental expense? It is not. Nowhere in TurboTax, or any other tax program for that matter, are you asked for your down payment amount on real estate.

[u0d4n7a0p]

@Carl 

Tax programs/software are not asking me this question. 

I am trying to figure out debt allocation. Do I have no choice other than allocating 25% of debt to the 25% portion which is leased to a tenant? Or can I allocate the way I described in my last message? 

[tagteam]

---

@u0d4n7a0p wrote:

@Carl 

My question is about debt allocation under 1.163-8T. 

---

Page @Rick19744 for this. @Carl is addressing a completely different issue (he doesn't understand the nature of the question you are asking).

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

[Carl]

You don't allocate just the debt. You allocate based on the "ENTIRE" cost basis Your cost basis is $1.2M. Period. With 25% for the ADO, that means you allocate $300,000 to the ADU as the cost basis on the SCH E. Of course, a portion of that amount will be allocated to the same percentage (25%) of the land. But the program will work you though that.
The remaining 75% of your cost basis is not entered anywhere on your tax return. But to clarify, depending on your situation the program "MAY" ask for the total cost basis, and then ask you what percentage of the property is business use (rental). In your case, you'd answer with 25% and the program (not you) would allocate 25% of your cost basis ($300,000) to the rental.  But weather the program works this way "FOR YOU" depends on how you answer questions and the data you provide to the program.

I also can't stress enough the importance of reading "EVERYTHING" on every screen before you enter data or make a selection. Also, pay close attention to wording. There is a difference between "select all that apply" and "select the one that applies".

[u0d4n7a0p]

@Carl 

Yes, cost basis of ADU (25% portion which is leased to a tenant) is 25% of total purchase price which is 300K.
Now, what portion of 1 million debt be allocated as debt incurred for acquiring the ADU? Is it 25% of 1million (which is total loan amount). Or can I say 300K was incurred for acquiring the ADU portion (Thus in effect saying that debt allocated for Primary Residence portion is 700K and thus entire down payment of 200K was towards the primary residence)? @Rick19744 

Thanks @tagteam 

[Rick19744]

@u0d4n7a0p 

Some comments related to your question(s):

• The specific language of Treasury Regulation 1.163-8T states "In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense related is allocated......"
• True this is a temporary regulation and has been around for quite awhile, this is still the IRS' position on this matter and has not had any significant Court push back.
• While all of your debt is related to just a single purchase, based on the underlying premise of the regulation, I believe you should be following your 75/25 ratio.  This is because these rules are "interest tracing rules", and tracing this interest based on your facts, I believe you arrive at the 75/25.
• Anything outside of this allocation would most likely require you filing form 8275-R.  Filing this form with your tax return is probably a certainty for an audit along with justification as to why your allocation is superior to that in the regulation.
• TT most likely does not accommodate this allocation and it will need to be entered manually in the appropriate section of the program.
• This doesn't mean that you are stuck with this allocation forever.  If your facts change, then the allocation can change as well.  So if at some point this no longer has any rental, then you can allocate 100% to the primary residence.

[u0d4n7a0p]

@Rick19744 Thanks a lot.

I assume turbotax does allow you to do 75:25 once you enter the right data about 25% being rental portion,

Does turbo tax allow you to say that all the debt being repaid is adjusted towards the principal amount on the primary portion? We did discuss in this thread that dept repayment tracing lets you adjust the repayment towards personal loan before adjusting it towards rental which yields you income (and thus tax liability)

[Rick19744]

@u0d4n7a0p 

Can't address those questions.  TT input questions are not my forte; assuming I have a forte to begin with. 😎

[u0d4n7a0p]

@Rick19744 @Carl 

Thanks for your comments. I appreciate the time spent by you to help the community.

Regardless of how turbotax does it, I guess for IRS, ADU portion is just another property in Schedule-E isn't it? As in, if I were to do everything manually (without any software), I would caclualte and fill in in interest expense for the ADU property on my own and the said ADU portion/property will be just another property. Please comment.