interest allocation of mixed use mortgage

you are on the right track...I assume that you purchased your home prior to Dec, 2017. 

 

I assume what you are stating is you took out a $500,000 loan collateralized by your primary residence, paying off the original mortgage of $150,000 and used the $350,000 of cash out to buy a rental property; there is no debt on the rental property.

 

Line 1: 0

Line  2: 150,000

Line 3: $1,000,000

Line 4: $1,000,000

Line 5: $150,000

Linr 6: $150,000

Line 7: $0

line 8: $750,000

line 9: $750,000

Line 10: $150,000

Line 11: $150,000

Line 12: $150,000

 

"If line 11 is equal to or more than line 12, stop here. All of your interest on all the mortgages included on line 12 is deductible as home mortgage interest on Schedule A"

 

read the instructions closely!  The interest RELATED TO THE $150,000 is all deductible.  it says the interest related to the mortgages on Line 12 is deductible, not that ALL the interest related to the $500,000 is deductible!

 

and you are correct that the Schedule A deductible interest is $150,000 times the interest rate.  And it will be that simple until the total mortgage amortizes down to $150,000 at which time all the interest will be SChedule A deductible.  

 

if you sell the rental before the mortgage amortizes down to $150,000 (and not buy another rental property with the proceeds), the interest related to the mortgage part that exceeds $150,000 is not deductible ANYWHERE.  

 

 

Thank you!  Answer makes sense - have 2 followup questions

 

1. In the context of your answer, how would I report the interest on the federal tax return?  In the above example, I would have to allocate all the interest in sch E and none to the home acquisition portion. I receive a 1098. Say that it shows interest of $25k. If I have a1098 form in turbotax reporting $25k in interest, it autopopulates $25k in sch A.   Do I override the $25k in the 1098?  Then there is an inconsistency in the reported 1098 and what I report.   I know how to enter interest in Sch E, so that is straightforward.

 

2.  It turns out that CA tax law is different than federal in that CA tax law allows you to deduct up to $100k of home equity debt as acquisition debt.  Q 2a) When it says you can deduct up to $100k of home equity debt, do you have to?  If it is optional, then it is easier to keep one set of books instead of 2 and keep CA state consistent with CA.  Q 2b)  There is an advantage of deducting $100k as home equity debt because that increases the amount that can be itemized in CA.  In the above example, the interest of $25k would be divided between $5k as CA home acquisition debt/equity debt and $20k rental prop debt. Would like to know if it is optional or required to take the deduction of $100k.

 

Thanks!

 

 

1) yes, just override the 25k.  there is no inconsistency.  If you are ever audited by the IRS, you have the documentation to show how you deducted some interest on Sch A and the rest on Scd E.  

 

2.  No you don't have to. Taxing authories "love it" when you don't take deductions entited to you.  While I am not really familiar with CA taxes, you may be better off following the CA rules.  Here's why: on the federal return, you are likely a passive investor, so your losses are only deductible up to a point (the rest are deferred to a future year).  If CA works similarly, then you would want to take the deduction as a personal deduction and not a real estate deduction so that you can take the deduction now versus years into the future.  Something to look into.   

 

 

One more question:

Suppose I refi this mixed used mortgage loan.  Say at the time of refi of the above example, there is a balance of $450k left on the loan, $150k home acquisition debt (the same as when I took out the first mixed-use mortgage) and $300k of home equity debt used for rental property acquisition (paid $50k of principle).  But I refi the loan secured by my principle residence for $400k and contribute $50k of cash from my personal account (i keep separate accounts and books) to pay down my $150k home acqusition debt.  can I now allocate for the refi $100k of home acqusition debt and $300k of home equity debt?  Or does the IRS consider a refi the same loan and apply all principle reductions including prepayments to reducing home equity debt first?  If the latter, it means that I can never reduce home acquistion debt until the home equity debt is paid off, even if new loans are taken. 

paydowns affect the non-aquisition debt first.  That is true whether it is due to normal amortization from monthly payments or you decide to make a siginficant principle payment to paydown the debt.

 

but that is to your advantage,  

 

the interest on the aquisition debt is tax deductible; the interest on the rest of the debt is not deductible.  So you'd want to pay down the non-deductible debt first. 

 

As I stated previously, taxing authorities really don't care if you take less of a deduction than you are entitied to - it saves the taxing authority money.  So if you really wanted to paydown / payoff the aquisition debt first, which means less of the interest is tax deductible, the IRS is not going to care.... as the end result is you are paying more in tax than you are otherwise obligated to. 

Sorry, I am now confused.  I want to understand what the IRS rules require.  You say that the rules require you to offset the home equity debt first, then say it doesnt matter, so I am confused. 

 

According to pub 936, it says "

 

In case you are wondering why I want to decrease my home acquisition debt, it is because I no longer itemize for federal.  So any interest I pay on home acquisition debt is lost and not deductible.  Whereas equity debt that I can use for Sch E either offsets income now or later.  So for the federal, I prefer to minimize home acquistion debt and maximize home equity debt.  Paying the debt down to a certain limit (conventional) lowers interest rates.

 

Thank you!

I am going to modify my earlier statement.  

 

There actually is a statement on how to allocate when there is a mixed use mortgage. 

 

https://www.irs.gov/pub/irs-pdf/p936.pdf

 

on a mixed use mortgage, there is a prescribed paydown order.  you don't have a choice:  (Page 12 - right side).  If you decide to make a $50k paydown, it has to go against the non-aquisition debt first.  

 

"Figure the balance of that category of debt for each month. This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order.
a. First, any home equity debt not used to buy, build, or substantially improve
the home.
b. Next, any grandfathered debt.
c. Finally, any home acquisition debt. "

I am aware of that statement in IRS pub 936.  However, it applies to paying down an existing loan.  If I do a cash-in refi, Pub 936 is more vague.  It only says that for a refi, you cannot ascribe more to the home acquisition loan amount than what it was from the prior loan.  There is nothing that says you cannot ascribe less to the home acquisition loan amount on a refi.  It seems that when  you do a cash-in refi, you are taking a new mixed-use loan and can assign the cash in to either category of debt.  It seems that the paydown rule you state only prescribes the cash in allocation if the IRS considers a refi a continuation of the same loan subject to the same paydown rules, but it doesnt state that explicitly anywhere in pub 936. 

<<However, it applies to paying down an existing loan.>>

 

and that is EXACTLY what you are doing!!!!!  You are paying down a existing loan! ("paying off" a mortgage loan is just a more extreme form of "pay down" of a mortgage loan)

 

let's use an example.

 

I have a mortgage for $150,000.which I refinance up to $500,000, so $350,000 is non-aquisition debt. 

 

Then i decide to refinance again and bring the balance down to $450,000. 

 

First, I need to pay down the current mortgage company $50,000 in cash from my own pocket; it has nothing do to with the new mortgage company as they are not lending me that $50,000. They expect it to be paid down prior to them lending me the money (even if it on the closing statement, it is still 'prior to', by a nano-second, of them lending me the money). 

 

Per the IRS 'rules of order" that $50,000 principle paydown has to pay down the non-aquisition debt.   

 

Whether I pay down the mortgage by $50,000 without doing a 2nd refinance or do it as part of the refinance (what you call a 'cash in') the mortgage pay down is still occuring while the current $500,000 mortgage loan exists and the IRS rules of order state that that principle payments on an existing mortgage pay down non-aquisition debt first. 

 

Then the new mortgage company lends me $450,000.  $150,000 is aquisition debt and $300,000 is non-aqulsition debt. 

 

This is very clear to me (and I was in the mortgage business for years) but at the end of the day, it is your tax return! and your risk of IRS audit! 

 

 

 

 

First I want to express my appreciation of your thoughts on this matter.  It is hard to find a knowledgeable person in this specific area.

 

I think what you said in your last post makes sense. 

Now that I understand what should be done, I am now struggling in turbotax to do it correctly.

Turbotax doesnt have the forms in IRS pub 936.  Instead, it has a home mortgage interest worksheet and within that, it has a home mortgage limitation smart worksheet that comes up with numbers without explaining what calculations it uses.  I cannot find in pub 936 a copy of this worksheet.  How it calculates the home acquisition interest = total interest paid x (acquisition debt/ending principle balance).   (Figured it out by trial and error).

 

This is NOT one of the accepted ways listed in pub 936, as pub 936 keeps discussing using average balance, not end of year balance.  Is this worksheet in turbotax simply wrong?

suggestion : just use your own calculations.  If ever audited by the IRS, you have documentatin on how you did it. You are not beholden to TT's method. 

 

it is rather easy:  the aquisition interest is the interest rate times the $150,000; since it is not amortizing, it is that simple.  Whatever was reported by the bank less the aquisiiton interest  is the non-aquisition interest. 

 

TT's calculation should be close to what I stated above but I agree it could have been simpler.  

The challenge in turbotax is how to change from the easystep inputs without messing other things up.  The other issue is that if you override any calculated value, it prevents electronic filing, so I avoid overriding any calculated value.   The last issue is that many cells you cannot find where they are calculated from. 

 

So the first thing I tried was to use easystep.  That gave the wrong answer and filled out the interest expense worksheet incorrectly.  The next thing I tried was to go to the interest expense worksheet and that fill out.  That resulted in what was a simple calculation as you stated above and turning it into a wrong answer.  I then tried to enter the correct mortgage interest into Sch A and it required me to override the calculation from the interest worksheet and that prevents electronic filing.   I then realized that the 1098 forms are not included in the efile, so I deleted them from turbotax, deleted the interest worksheet and then turbotax allowed me to directly enter the interest in Sch A without overriding any calculated value as well as entering the equity interest in Sch E.  I thought that was a solution.  But then, when I went into the state return, since there was no 1098 entered into turbotax and no interest worksheet, the state was not correct.  That is where I am now. 

 

I will try next to put the 1098s back in, the interest worksheet back in, get the wrong answer but see where the info propagates to the CA return and manually try to fix all.   Urgh....

idea: enter TWO 1098 forms - one for the non-aquisition interest and one for the aquisition interest.  The IRS is not going to 'tick and tie' the 1098 on your submission versus what the servicer submitted.  

 

are you using the online version or the CD/Download version.  on the CD / download version it is quite simple to go into "forms mode" and create two 1098s. 

Absolutely brilliant suggestion!

 

I created 2 1098s, one that was purely home acquisition debt and the other purely home equity debt, using the manual numbers (a question later on this), as if there were 2 loans separated in the above manner. Turbotax allocated the entire home acquisition debt on Sch A and none of the home equity debt.  Then in the CA tax form, I made sure the interest worksheet reflected the same numbers.  CA has a different tax law than federal in that 100k of home equity debt can be included in the home acquisition debt.  So it did the numbers automatically and gave me more deductions!  So your suggestion works!

 

Thanks again!  I think that concludes this issue.  I would hope this rather long thread can be archived for other people's reference, as is is not discussed anywhere else in this detail I could easily find.

I came across this thread while researching another issue and wanted to comment.

 

Your discovery that turbo tax uses the ending balances instead of the average balances to calculate the percentage of deductible interest is correct. It's been like this for a few years now. This method is not anywhere in Pub 936 but does allow a slightly higher deduction. Don't bother reporting it. I did last year and it did no good.

 

Pub 936 Table 1 Line 12 is the total mortgage average balance including both acquisition and equity debt. The instructions for Line 12 refer to the averaging method for mixed-use mortgages but these instructions are incomplete and misleading.

 

Step 2 of the averaging method for mixed-used mortgages simply says to add the monthly balances together but does not say to divide each category total by the appropriate number of months to get the average. This is the number of months the home that secures the mortgage was a qualified home (as in the Statement Balance averaging method).

 

Step 2 only includes the Grandfathered and Acquisition debt in the total balance and omits equity debt. This balance is needed to calculate the total average balance for Table 1 step 12. Step 2 needs to specify summing the Grandfathered, Acquisition, and Equity debt balances to get the total average balance.

 

@whodiini @NCperson 

@Whodini @NCperson 

Say your home acquisition indebtedness is 150K and borrrow 500K  in total against the home in a refinance. To begin with your new home acquisition indebtedness is at 150K. Now rest 350K is __not__  home equity indebtedness anymore once you assign it to buy a rental. Interest expense for this 350K is deductible in schedule E against the income on the rental property.  Say you buy a a car for 350K, at this point interest incurred on 350 K can't be set off against anything.   You have a choice to pay off personal loans (loans for which you can't set off incurred interest against anything) before you pay off loans which are sued for earning interest. In your case, you can first pay off your rental home and then start paying off your primary home. Your mortgage on home was 150K and because all of 350K out of 500K was used for rental home, you have 0 home equity indebtedness, you have assigned that loan to the rental. 

I followed everything you stated until the last sentence "Your mortgage on home was 150K and because all of 350K out of 500K was used for rental home, you have 0 home equity indebtedness, you have assigned that loan to the rental. "  If you do a refi for $500k and there is $150k left on your home mortgage and you use $350k for rental home, you should still be able allocate $150k for your home mortgage and $350k for your rental home.  From a deduction perspective, you will need to allocate all the interest to your rental home until $350k of the principle has been paid off. Only then can you start deducting the interest from the $150k for your home.  You still have $150k home equity indebtiness but you cannot deduct the interest until you have paid the $350k allocated to your rental home. 

Out of 500K loan, 150K is home acquisition indebtedness and 350K is home equity indebtedness. Now when 350K was used for buying the rental home, 350K changed from being home equity indebtedness to being a loan which was used to borrow a property which generates income. Because income is taxed, the interest incurred for generating that income can be set of against the same. Here is how loan split looks like:

Home acquisition indebtedness 150K

Home equity indebtedness 0

Loan which funded rental 350K

Now, you have no obligation to pay off 350K before you pay off 150K, You can account such that everything you are paying off in a year is bringing 150K down till you have nothing left to pay off in 150K and then starts paying off 350K. Remember, 350 loan is generating you income and income is taxed. Interest on the loan can be set off against that interest.

Please let me know whether you have a different take on this. 

I see,  I did not understand your distinction between home acquisition and home equity.  So I agree zero home equity indebteness. 

 

I do not agree with your last paragraph, at least how I read the IRS rules. Your post has made me revisit this topic.   See IRS publication 936, under mixed use mortgages.

" If the average balance consists of more than one category of debt (grandfathered debt, home acquisition debt, and home equity debt),

I am going to disagree @u0d4n7a0p as far as having a choice on paying down either the $150K acquisition debt or the $350K equity debt first. The refi on the primary home is a mixed-use mortgage consisting of both acquisition and equity debt. You have to apply all principal to the equity balance until it is paid down before applying principal to the acquisition balance. It doesn't matter if the equity portion was used to purchase a rental home.

 

The schedule A deduction is (acquisition debt balance) / (total mortgage balance) = 150K / 500K = 30% of the total mortgage interest paid. The remaining interest is a rental expense that can be reported on schedule E.

Search for " Tax-Deductible Interest: Understanding IRS Tracing Rules" and   Also search for  "IRS memo number " 

Allocation of interest expense among expenditures"

You can choose how you are allocating the debt. 

 

 

@whodiini @Zomic 

 

Are we agreeing that in this case, one can choose to pay off 150K home acquisition debt first before starting to pay off 350 debt which was used for rental purpose. How you account for principal pay off effects how much interest deduction you cant take on rental. If interest on 150K  would be low enough to just take standard deduction. 

IRS memo number 201201017

Your interpretation is almost the same as my interpretation.  That the money used for rental property is considered equity debt. If so, then you have to apply all principal to the equity balance. Then the schedule A deduction is not 30% of the total mortgage interest paid. It is a fixed amount (interest rate*150k) per year until the principal is reduced to 150k and then it is the entire mortgage interest  after that.