interest allocation of mixed use mortgage

[whodiini]

I am having a tough time with IRS Pub 936, their definitions and their worksheets

I did a refi of my primary home in 2022 and took cash out and used the money for a rental home refi. So this is called mixed -use mortgage.  A portion is home acquisition debt and a portion is home equity debt used for investment (?).  Assume that everything is less that the $1M limit and is not grandfathered debt before 1987.

Say that  I did the refi Jan 1 (to make it simpler), the new loan was $500k, and $150k was applied as home acquisition debt and $350k was applied to the rental home.  The original mortgage for the home acquisition was $400k. 

According to pub 936, I first need to figure out in Part I worksheet, the maximum loan amount I can attribute to home acquisition debt.  That seems straightforward. Since the refi, I had $150k of home acquisition debt, that is the amount I ccan get on line 11 as the qualified loan limit.  (Pub 936 says I need to pay off the non-acquisition debt first, so all my principle payments go to paying off the $350k, so in 2022, I havent paid any principle from the $150k of home acquisition debt.)

Part II, deductiible home mortgage interest is where I can stuck.  

I would think that what makes sense is that the amount of interest I can attribute to the home mortgage to put on Sch A would be the interest rate X $150k and the remainder would be on Sch E such that the sum is what is reported on the 1098.  But that isnt how the part II worksheet says.  Line 12 says to use the mixed use mortgage instructions, which say to add grandfathered debt and home acquisition debt and enter in line 12.  Since the $150k hasnt changed, that is entered in line 12. Then it says if this is the same as the qualified loan limit (which it is), then all the interest is deductibe as home mortgage in Sch A.  This doesnt make sense.  It would make sense if line 12 included the home equity portion but pub 936 specifically doesnt include that.

What dont I understand or is Pub 936 wrong for line 12?

[NCperson · Accepted solution]

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.  

[whodiini]

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!

[NCperson]

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.   

[whodiini]

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. 

[NCperson]

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. 

[whodiini]

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 "

Refinanced home acquisition debt.

Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt not used to buy, build, or substantially improve a qualified home isn't home acquisition debt."

But it doesnt say how you allocate the refi debt if it is lower. 

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!

[NCperson]

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. "

[whodiini]

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. 

[NCperson]

<<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! 

[whodiini]

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?

[NCperson]

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.  

[whodiini]

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....

[NCperson]

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. 

[whodiini]

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.