Mortgage Interest Deduction (Rental or Primay)?

[Andreas2]

If I took a cash out refinance specifically on my primary residence home and used it to buy rental property outright, would the mortgage interest each year be attributable to:  (1) 100% as primary home on Schedule A;  (2) 100% as rental property expense on Sched E; or (3) split between both sched A & E based on the % of the refi mortgage that went to rental property and % went to the remainder pay off on the previous loan balance?   Greatly appreciate any insight and welcome guidance to the pub/source. 

[TomD8]

If you use the proceeds of a home loan to purchase rental property, the interest is entered on Schedule E.

https://turbotax.intuit.com/tax-tips/home-ownership/deducting-mortgage-interest-faqs/L4a9KF9mI

[NCperson · Accepted solution]

@Andreas2 

1) On schedule A, you can only deduction mortgage interest related to the balance of the prior mortgage with no cash out.  

2) On schedule E, yuou can deduct the interest related to the invest property.

3) it is possible SOME of the interest is not tax deductible at all./

You question poses 3 possible outcomes, but there is a 4th, which is more likely than the 3 you asked about. 

Let's say your existing mortgage balance was $200,000 and you cash-out refinanced $300.,000.  Then you invested $55,000 to purchase an investment property.

1) The interest rate times the $200,000 is deductib;e on Schedule A.

2)The intest rate times the $55,000 is deductib;e on Schedule E

3) The remaining interest is not tax deductibe.  

As the mortgage amortizes over time, item 3 amortizes first (meaning the balance of #1 and #2 will not change for many years.  Once the loan amortizes down to $255,000, the mortgage (and the related interest) of #2 amortizes.  Once tbe mortgage is below $200,000, all the interest goes on Schedule A. 

If you later sell the invest property, only the interest related to the $200,000 is tax deductible.  The rest is not (unless of course you invested in annother property)

[Mike9241]

as to the refi. any amount over and above the mortgage balance on the date of the refi is not personal residential interest so it does not go on schedule A. the cash out to the extent used to acquire rental property goes on schedule E under the IRS tracing rules. The deductibility of any cash not used on the rental depends on what it is used for.  -if personal the interest is not deductible.

also the interest deductible allocable to your home may also be limited if the mortgage balance at the time of the refi exceeds the respective cap 

[Opus 17]

First point. Mortgage interest is deductible on schedule A for your main home and one second home, up to a combined limit of $750,000. In order to be deductible, the mortgage cannot exceed the acquisition cost of the home.  For example, suppose you bought the home for $100,000 and your mortgage balance is currently $50,000. The home is worth $300,000, allowing you to take out a $200,000 home equity line of credit. Only $50,000 of the equity loan would be deductible interest, because that is the limit of your acquisition cost.  So, depending on your other circumstances, you might be able to take out a mortgage on your main home, use it to purchase a rental property, and deduct some of the interest on schedule A, but maybe not all of it.

Second point. You can deduct the interest on schedule E, for a loan that you use to buy the rental property, regardless of where the loan came from or how it was secured, even if it was secured as a mortgage on your main home. There is no upper limit on the schedule E mortgage deduction like there is on a personal home mortgage.  Deducting the interest on schedule E lowers your taxable rental profit, which is generally a good idea.  

However, there are two additional points that you need to be aware of.

Third point. You must be able to follow the tracing rules with your deductible interest. For example, if you use the home mortgage to entirely buy a rental property, and nothing else, then you can trace the interest to the rental property. However, if you use some of the mortgage to pay off bills or take a vacation, then it becomes more difficult to trace the interest from the mortgage to the rental property. And the more complicated you make your finances and the more things you use the money for, the harder it is to trace the expense. If you can’t prove the interest is traceable, you would lose the deduction in an audit. 

Fourth point.  In order to treat the loan as a business loan to deduct rental interest in schedule E, you have to make an election (choice) to treat the loan as if it was not secured by your home.  That means you can never deduct the interest as a personal mortgage on Schedule A, even if your circumstances change and it would be better to do so.  

[TomD8]

"That means you can never deduct the interest as a personal mortgage on Schedule A, even if your circumstances change and it would be better to do so." 

I don't believe that's correct.  If you convert a rental to personal use as a first or second home, then you may begin to deduct the mortgage interest and property taxes on Schedule A.  But you may no longer deduct what were other rental expenses, such as repairs or depreciation.

https://www.nolo.com/legal-encyclopedia/taxes-when-you-convert-your-rental-property-your-personal-re....

[NCperson]

@TomD8- I do beleive @Opus 17 is correct, but I think there is confusion in the scenarios.

If the loan is taken out against home A (which is the personal residence) to use as a down payment against investment property B, then that interest can only be deducted on Schedule E.  It can never be deducted on schedule A (even if investment property B was sold) because the money that was borrowed against Property A was not aquisition debt nor was it used to extend the life of Property A.   I believe that is the scenario in this thread.

I think the article you provided is a different scenario.  in that scenario, the loan is against investment property B.  So if the owner ceases renting it and moves into the property (or uses it as a 2nd home), the interest related to the aquisition debt can now be deducted on Schedule A. 

At least that as how I see it. 

[Opus 17]

@TomD8 

@NCperson 

There is language in the code about making an election to treat a mortgage as not secured by a home.  That election can only be reversed by the approval of the Secretary (of the Treasury -- i.e. the IRS).  To treat the mortgage as a loan to buy an investment, you have to treat is as not secured by the personal home.  Once the loan is treated as not secured, it is ineligible for schedule A, and since there is no practical procedure to get IRS approval to reverse the election, the election is permanent, at least on a practical basis.

I'm traveling and can't look up the exact citation, but we have discussed the situation here before several times (I can't look that up either, sorry).  

I also have not read the Nolo article but @NCperson 's explanation makes sense to me for the scenario described.  In the B scenario, there was never an election to treat the B mortgage as not secured by the B property, so when the B property becomes a personal home, the mortgage is secured by the home and is eligible for the schedule A deduction.