Refinancing primary residence to pay for down payment on investment property

[Vic14]

I plan to cash out refinance my primary residence and use to proceeds for down payment on an investment property.  I was wondering if the interest I pay on down payment can be deducted as investment interest?

[Opus 17 · Accepted solution]

There have been several discussions of this recently and I think the final consensus is this:

If part of the loan would still be for acquisition debt on your personal residence and you want to deduct a portion of the interest on schedule A, then you can't deduct the other part of the interest as an investment expense.  Remember that your home mortgage is only deductible to the extent the money is used to buy build or substantially improve your home.  Any other debt is equity debt and the interest on equity debt is not deductible as mortgage interest on schedule A.  Suppose you have an original purchase mortgage with a remaining balance of $50,000, that is acquisition debt.  If you did a cash out refinance for $150,000, then your acquisition debt is still only $50,000 and only 33% of the interest is deductible on schedule A as personal mortgage interest, (unless you used part of the money to substantially improve your home of course). 

To deduct the interest as mortgage interest on the investment property, you have to make an election to treat the loan which is secured by your personal home as not secured by the home.  (You just make the election in your own mind, you don't have to file paperwork, but once made, the election can't be changed back.). Then you also have to be able to apply the tracing rules to allocate the interest properly to the investment property.  You need a paper trail that shows that the interest is directly tied to the investment property.  It's simple enough if you refinance and use the cash for the investment property, but becomes more complicated and harder to prove if you also take cash out for vacations, cars, and other personal expenses.  It becomes harder and harder to allocate a particular dollar of interest to the investment property.

So in my above example, if you refinanced a $50,000 purchase mortgage into $150,000 and used the $100,000 for your investment, you could deduct either 1/3 the interest on schedule A as a home mortgage, or 2/3 the interest as an investment expense, but not both. 

[Vic14]

Thanks for clarifying this. What if I use HELOC secured by my principal residence to pay for down payment on investment property? I will use entire HELOC proceed for down payment and not mix with other payments. Will the HELOC interest be considered investment interest?

[NCperson]

@Opus 17 

<<if you refinanced a $50,000 purchase mortgage into $150,000 and used the $100,000 for your investment, you could deduct either 1/3 the interest on schedule A as a home mortgage, or 2/3 the interest as an investment expense, but not both.>>

and I think the way it technically works is that as the $150,000 mortgage pays down, the acquisition debt remains at $50,000, so while the interest allocated to the personal home would stay constant for quite awhile, the interest on the investment property would go all the way to zero before the interest on the acquisition debt went down. 

So it's really easy to calculate.  Adding on to your example... and saying the interest rate is 4%

then  $2,000 of interest each year ($50,000 * 4%) would be part of Schedule A each year and the rest of the interest would be part of the investment property expense.   The interest related to acquisition debt wouldn't go down until the mortgage balance was less than $50,000.

[Anonymous_]

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@NCperson wrote:

....$2,000 of interest each year ($50,000 * 4%) would be part of Schedule A each year and the rest of the interest would be part of the investment property expense....

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The problem with that reasoning is CCA 201201017, which essentially states that the election to treat debt as not secured by the qualified residence must apply to the entire indebtedness.

See https://www.irs.gov/pub/irs-wd/1201017.pdf

[Opus 17]

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@NCperson wrote:

then  $2,000 of interest each year ($50,000 * 4%) would be part of Schedule A each year and the rest of the interest would be part of the investment property expense.   The interest related to acquisition debt wouldn't go down until the mortgage balance was less than $50,000.

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You are correct that if the taxpayer chooses to treat the debt as personal mortgage interest, the taxpayer can treat any payments as paying off the equity debt first, regardless of what the equity debt is used for.  That would mean that in the first year, perhaps 33% of the interest would be deductible on schedule A; in the second year, 35% would be deductible on schedule A, and so on.  However, our best reading of the relevant instructions and codes is that the equity debt can not be deducted as a business expense at the same time as the acquisition debt is deducted as personal mortgage interest.

if the taxpayer makes the election to treat the debt as not secured by the home, then the equity portion that was used to pay for the commercial property could be deducted as a business debt, as long as the tracing rules are also met.  But since a personal mortgage must be secured by the home in order to deduct the interest on schedule A, if the taxpayer makes the election to treat the loan as unsecured, then the portion that is acquisition debt for the personal home is no longer deductible on schedule A.  

The taxpayer may deduct the personal mortgage expense only, or the equity debt only if the tracing rules are met as a business expense, but not both.

[Opus 17]

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@Vic14 wrote:

Thanks for clarifying this. What if I use HELOC secured by my principal residence to pay for down payment on investment property? I will use entire HELOC proceed for down payment and not mix with other payments. Will the HELOC interest be considered investment interest?

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As stated, to treat the loan interest as investment interest, you must elect to treat the loan as not secured by your home.  This means you can't deduct it as mortgage interest on schedule A, now or in the future.

Second, you must meet the tracing rules, or to say it another way, you must be able to prove that the interest is legitimately allocated to the investment property.  As long as you have a single loan and all the proceeds went to the investment, it should be easy to prove that the interest can be allocated to the investment.  However, if you use additional loan proceeds for other, non-investment purposes, you muddy the water and make it harder for yourself to prove, if audited, that the interest can be allocated to the investment.