Deducting interest

[Jrdub]

I took out a HELOC loan on my primary residence to purchase rental property. Can I deduct the interest as an expense using it as a passive activity?

[LJane29]

Unfortunately the interest won't be deductible.  It was not used to buy, build or purchase the primary home so it can't be taken as a part of itemized deductions (personal use).  On the rental side, because the lien for the loan is NOT against the rental property then the interest is not deductible.

[Jrdub]

Even if it's considered a "passive activity interest"?

[LJane29]

Yes, it is based on what is securing the loan (your primary home) and what the loan is being used for (rental property).  It wouldn't matter if it was passive (almost all rental income is categorized as passive) or active income generating.

[Jrdub]

Does the interest tracing rules apply if I used the proceeds of the loan within 30 days?

[Opus 17]

A loan that services a rental property does not have to be secured by the rental property to be a deductible business/rental expense.  Basically, you could buy the rental property with a secured mortgage, an unsecured personal loan, or even credit cards, and the interest is deductible as a rental expense against rental income.  This is covered in IRS publication 535, page 14.  https://www.irs.gov/pub/irs-pdf/p535.pdf

The tracing rules say you must be able to trace the interest you want to deduct to the business purpose.  That's ok if you take out an HELOC and use the entire amount to buy an investment property.  However, if you take another draw from the HELOC for a new car, or a vacation, or an improvement on your main home, then you muddy the waters and it become much harder to trace a specific dollar of interest back to the business property.

However, there is a special caveat with respect to a loan secured by your own home.  You can treat it as a secured loan for the schedule A itemized mortgage interest deduction, or as an unsecured loan for other purposes, but not both.  That means that if you make the election to treat the loan as a business loan for the rental, you can't go back later and treat it as a mortgage for the schedule A mortgage interest deduction, even if you use part of the HELOC for a home improvement that would normally qualify for the mortgage interest deduction.

See https://www.law.cornell.edu/cfr/text/26/1.163-10T

(5) Election to treat debt as not secured by a qualified residence -

(i) In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

[Opus 17]

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@LJane29 wrote:

Yes, it is based on what is securing the loan (your primary home) and what the loan is being used for (rental property).  It wouldn't matter if it was passive (almost all rental income is categorized as passive) or active income generating.

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see https://www.law.cornell.edu/cfr/text/26/1.163-10T

(5) Election to treat debt as not secured by a qualified residence -

(i) In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

(ii) Example. T owns a principal residence with a fair market value of $75,000 and an adjusted purchase price of $40,000. In 1988, debt A, the proceeds of which were used to purchase the residence, has an average balance of $15,000. The proceeds of debt B, which is secured by a second mortgage on the property, are allocable to T's trade or business under § 1.163-8T and has an average balance of $25,000. In 1988, T incurs debt C, which is also secured by T's principal residence and which has an average balance in 1988 of $5,000. In the absence of an election to treat debt B as unsecured, the applicable debt limit for debt C in 1988 under paragraph (e) of this section would be zero dollars ($40,000−$15,000−$25,000) and none of the interest paid on debt C would be qualified residence interest. If, however, T makes or has previously made an election pursuant to paragraph (o)(5)(i) of this section to treat debt B as not secured by the residence, the applicable debt limit for debt C would be $25,000 ($40,000−$15,000), and all of the interest paid on debt C during the taxable year would be qualified residence interest. Since the proceeds of debt B are allocable to T's trade or business under § 1.163-8T, interest on debt B may be deductible under other sections of the Internal Revenue Code.

[Jrdub]

So, it sounds like I can use as an unsecured loan and claim the interest as a business expense for the rental property. Do I have that right?

[Opus 17]

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@Jrdub wrote:

So, it sounds like I can use as an unsecured loan and claim the interest as a business expense for the rental property. Do I have that right?

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I believe so, yes,  You make the election to treat the loan as unsecured under section 10T(o)(5) simply by declaring the interest as a business expense, you don't do anything special to notify the IRS of the election.  You still need to be able to follow the tracing rules, and the HELOC is not eligible to be deducted as schedule A itemized mortgage interest, now or in the future.