interest allocation of mixed use mortgage

[zomboo]

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 

[u0d4n7a0p]

@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. 

[whodiini]

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. 

[u0d4n7a0p]

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. 

[whodiini]

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),

1. 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.

   1. First, any home equity debt not used to buy, build, or substantially improve the home.

   2. Next, any grandfathered debt.

   3. Finally, any home acquisition debt.

2. Add together the monthly balances figured for b and c in (1)."

Now here I equated the rental home debt portion as home equity debt.  That may be incorrect as  the rental debt portion is business use, not home equity debt.

When i look later on in pub 936, it says:

"If you did use all or part of any mortgage proceeds for business, investment, or other deductible activities, the part of the interest on line 16 that is allocable to those activities can be deducted as business, investment, or other deductible expense, subject to any limits that apply. ..."

What this means is that you deduct the interest amount allocated to business use, which is different that what I said earlier.  Either way, it doesnt agree with what you said .

Clear as mud.

[zomboo]

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.

[u0d4n7a0p]

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. 

 

[u0d4n7a0p]

@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. 

[u0d4n7a0p]

IRS memo number 201201017

[whodiini]

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.

[whodiini]

I decided to summarize my thoughts after bouncing back and forth on this issue to reduce some confusion.

In the example used by @u0d4n7a0p

where a $500k refi was done on a primary home and the $150k proceeds refied the remaining mortgage and $350k was used to fund a rental home:

Home acquisition indebtedness 150K

Home equity indebtedness 350k, which is used to fund rental

Note that there is not a separate category here of business use. It is the home equity debt used for business.  This is an important distinction.

Then publication 936 comes into play for mixed use mortgages:

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

1. 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.

   1. First, any home equity debt not used to buy, build, or substantially improve the home.

   2. Next, any grandfathered debt.

   3. Finally, any home acquisition debt.

2. Add together the monthly balances figured for b and c in (1)."

Then the deductible amount of interest follows the allocation of interest on the remaining principal.

e.g. Home acquisition interest = (interest rate*150k) until principle owed drops to 150k.  Home equity debt interest = total interest - home acquisition interest until $350k is paid off.

That is how I originally understood this to be.

[u0d4n7a0p]

@whodiini @zomboo 

Search for "handout tracing regulations. Mortgage Interest and the Tracing Regulations After the Tax" and read the first pdf file that you get in search hit

[u0d4n7a0p]

Specifically read from page 8. 

[zomboo]

@whodiini: You are misinterpreting the mixed-used rules you cited. For mixed-used mortgages, according to Pub 936, you have to figure the average for the Total Balance, Acquisition Balance, and Equity Balance separately. In order to do this, you have to keep a spread sheet of monthly balances of each category. Sum each category separately and divide by the number of months the home was a qualified home during the year. So now you have average total balance (500K), average acquisition balance (150K), and average equity balance (350K). Then the deductible interest is 150K / 500K = 30%. I don't know where you are getting the Interest Rate * 150K method from. There is an 'Interest paid divided by interest rate' method described in Pub 936 but it doesn't apply to mixed-used mortgages.

@u0d4n7a0p: No we are not agreeing that it is okay to pay down the 150K acquisition balance first. The sources you cited are rules for tracing interest expense to debt only. When it comes to mixed-use mortgages, these rules allow you to trace the interest on the equity balance to what it was use for, rental property.

[u0d4n7a0p]

debt repayment follows the same order. You can scroll down the pdf and see.