interest allocation of mixed use mortgage

[u0d4n7a0p]

@zomboo "Office of Chief Counsel nternal Revenue Service memorandum, Qualified Residence Interest Questions", Please read the memo. 

[zomboo]

I have read all of the sources you provided. I am especially familiar with the IRS memo and the Interest Tracing handout. Both of them are clarifications of Section 1.163-8T of the Tax Code 'Allocation of Interest Expense Among Expenditures' and apply only to the equity portion a mortgage. Please don't ask me to search for and read anything else.

[whodiini]

@zomboo:  You are partially correct in terms of how interest is calculated, and I was not correct in how to calculate it.  I oversimplified and I think you did too.  The actual amount splits the difference between our inaccurate methods.  I followed IRS 936 to the letter here.

I did a spreadsheet using the example of $500k total split $150k home acquisition and 350k home equity.

I used 5%, 30 year mortgage, starting Jan 1, so a full year of payments.

The average total balance for the year is $496052 because of payments reducing the principal.

Average acquisition balance is $150000

Average home equity balance is $346052 because of payments reducing the principal

Deductible interest is 150000/496052= .302  x total amount of interest.  (IRS 936 says round to 3 decimal places)

So deductible home interest is $7449.  vs  $7500 using my incorrect way of calculating, and vs  $7400 using your way of calculating (.3 x total amount of interest)

Might as well be accurate following pub 936.  Thanks for pointing this out. 

[u0d4n7a0p]

@zomboo 
' the Tax Code 'Allocation of Interest Expense Among Expenditures' and apply only to the equity portion a mortgage. `

Hi,

Could you please point me to anything IRS which says so?

[u0d4n7a0p]

@zomboo I am not being rhetorical. I want to learn this form you. 

Hypothetically, say I do a new purchase of a primary home which has ADU and say same has 25% square footage. Does 1.163T allow me to do the following?

1. Set aside 27% of the debt for ADU and 73% for the Primary home
2. Pay off Primary home debt first  (debt allocated for primary home could be more than 750K, interest deduction for the same is a separate discussion)
3. Pay off debt on ADU only after primary home is paid off?

[zomboo]

@u0d4n7a0pIn response to your asking for IRS reference that requires you to pay off the equity debt prior to the acquisition debt, I refer you to the handout you ask me to read, 'Mortgage Interest and the Tracing Regulations After the Tax Cuts and Jobs Act of 2017'. This  handout explains the order of payoff when a loan has different categories of debt in accordance with Section 1.163-8T of the tax code. Look at part B, 'Repayment Ordering Rules' on page 17. Personal debt is repaid first in the order. Home mortgage debt is classified as personal debt consisting of Acquisition debt and Equity debt. Pub 936 specifies that Equity debt is paid down before Acquisition debt. The $350K for the rental is equity debt because the rental home does not secure the loan. Note that interest on personal debt is generally not deductible but the tax code makes an exception for interest on home acquisition debt.

[u0d4n7a0p]

Thanks @zomboo. Say 1 million is the total borrowed amount and debt is divided 75:25 between primary and ADU, then I can start paying off ADU loan only after primary loan is paid off.  In other words, all the principal payments made for the loan is first adjusted toward 750K debt assigned to the primary.  Do we agree here?  

[zomboo]

As far as I know, an ADU is not a separate property from the primary home. Different states have their own rules on ADUs. But your hypothetical has a single loan of $1M. In this case, you have one mortgage on one property. There is no dividing the principal between the two. So no, we do not agree.

What is your obsession with paying off the ADU first?

[u0d4n7a0p]

I not saying ADU can be paid off first. I am saying primary Residence can be paid off first. ADU being part of same house is immaterial. It is generating passive income and passive income is taxed. Debt was used to acquire both primary residence as well as ADU.

Leave ADU, if you are using portion of home for business use right from day 1, don't you now have personal debt ( home acquisition debt is a personal debt) and a business debt?  You are paying interest on whole debt and whole debt is not for residential usage of the property. It includes business usage. Does paying off portion of debt on primary make sense here?

[whodiini]

I think if you are asking about deductibility of your home that is partially used for business use, that is covered in IRS pub 587.  That  is completely a separate topic than a mixed use mortgage deduction. There are rules and examples in pub 587 how to deduct mortgage interest with partial business use.  So none of the discussion applies on mixed use mortgages for your cited case, see pun 587. That is how I read it.

[zomboo]

If you are using portion of home for business, that does not technically mean a portion of the mortgage is personal or equity debt. It is all still acquisition debt. But you must now allocate a percentage of the acquisition debt to the business. So if 75% of the home is use for residential living, then 75% of the acquisition debt and interest is used in the calculations on schedule A and 25% is applied to the business. Refer to Pub 587.

[u0d4n7a0p]

@zomboo  If ADU is leased, then it is a passive business activity.  Copy paste of your observation from 1.163T 

"Personal debt is repaid first in the order. Home mortgage debt is classified as personal debt consisting of Acquisition debt and Equity debt. Pub 936 specifies that Note that interest on personal debt is generally not deductible but the tax code makes an exception for interest on home acquisition debt." 

If you borrow money and use it for personal/primary residence and a passive business activity, you do have mixed usage of debt. And thus need to (or have choice to?) pay off personal debt (debt on primary residence) before paying off debt allocated for the portion which generates passive activity income.

Are you sayin publication 587 says otherwise?

[zomboo]

@u0d4n7a0p: We need to end this conversation. You keep bringing up different scenarios and I don't know what you're really asking anymore. I will say it one more time. If you have a mortgage secured by your main home and use a portion of the proceeds for something other than the acquisition or improvement of that home, that portion of the mortgage is equity debt.  For a mixed-use mortgage, the equity portion of the debt is always paid down first. It doesn't matter if was for business or investment. Those costs are deducted elsewhere.

[u0d4n7a0p]

@zomboo  Perhaps what I am asking is not explicit - you are covering a scenario of refinance or HELOC where equity built in the home post acquisition is taped to borrow.  I am talking about a new mortgage. 

During a purchase of new home, you have down payment. At the point of availing that mortgage, that down payment is the equity you have in the whole house.  Rest of it is acquisition debt. Whole of acquisition debt is not availed for your primary residence. Along with primary residence, you are acquiring something which you use for business use (or for passive activity which produces income).   

In case it helps - assume 1.2 million is the purchase price of the home. 200K is down payment and 1 million is the mortgage. When you walk into the home, your equity in the home is 200K. Your acquisition debt is 1 million. 25% of the home is used for generating income through passive activity. What stops one from splitting acquisition debt of 1 million between debt on primary residence  (personal debt) and debt on passive income generating activity?

[zomboo]

Okay, I think I have a better understanding of what you're asking. Your assumption that the acquisition debt is divided between the primary residence portion of the home (75%) and the part of the home use for business (or for passive activity which produces income) is not correct. The acquisition debt is for the home in its entirety regardless of how the home is divided up and used. Do not think of it as splitting the mortgage acquisition debt between the primary residence and business. There is no paying down one side other the other. It's one mortgage, one debt. Instead, split the ongoing costs of operating the home, such as mortgage interest, property taxes, and utilities between the residence and business. See Pub 587.