Not all mortgage interest is deductible

May 5, 2006

© 2006 by Michael Gray, CPA

Probably the most common errors on income tax returns involving real estate are the presentation and amounts of mortgage interest deductions.

Just deduct the interest for the mortgages secured by your principal residence and a second residence as itemized deductions on Schedule A and the interest for mortgages secured by rental properties on the schedule of income and deductions for the properties on Schedule E, right? Probably wrong.

The main source of the errors is the routine practice of refinancing properties, taking cash out "tax free", and using the funds for other purposes, including buying other properties. In most cases, this practice brings a requirement for interest tracing into play.

In this report, I’ll briefly outline some of the rules that apply to deducting mortgage interest. After you read it, there’s a good chance that you’ll decide to have a tax consultant familiar with these rules prepare your income tax returns.

Types of interest

Under the income tax laws, there are different types of interest, subject to different limitations.

Personal interest is not tax deductible.

Interest for the acquisition or improvement of a principal residence or a second residence and secured by that residence is deductible as an itemized deduction on Schedule A, and is also deductible when computing the alternative minimum tax. The maximum debt for which this deduction may be claimed is $1 million.

Interest for "equity indebtedness" of up to $100,000, secured by a principal residence or a second residence is deductible as an itemized deduction on Schedule A but may be disallowed as personal interest or be subject to the investment interest limitation when computing the alternative minimum tax. An example would be borrowing money on an equity line of credit to buy a car. The $100,000 limit for equity indebtedness is in addition to the $1 million limit for qualified residential housing interest.

Investment interest is deductible up to the amount of investment income.

Business interest is generally deductible as an expense on the related form – Schedule C for a trade or business, Schedule E for a rental property, or Schedule F for a farm. Depending on the circumstances, losses from these operations may be subject to the passive activity loss limitations. Also, interest expense is not deducted, but capitalized, when property is under construction.

What happens when you refinance a mortgage secured by a qualified residence?

When you refinance a mortgage secured by a qualified residence, you are supposed to trace where the funds are used. This can be done most easily by depositing any loan proceeds in a separate account and paying the desired expenses from that account. The interest is then prorated into different categories according to the use of the funds. The IRS has issued fairly liberal regulations that let you allocate principal repayments most favorably for yourself.

For example, say you refinanced your home. Using a $500,000 loan, you paid off the mortgage balance of $300,000 from when you bought the home. $150,000 is used to remodel the home. $50,000 is used to buy a new car. Initially, interest will be allocated 90% as qualified residential housing interest and 10% as home equity interest. Since the home equity interest isn’t deductible on the AMT schedule, you can allocate principal payments first to that balance until it’s eliminated. Then all of the interest on the mortgage balance after the home equity piece is paid off will be residential housing interest.

What if you refinance your home for $500,000, paid off the $300,000 mortgage balance from when you bought the home, and used $200,000 to buy a second residence? Since the $200,000 loan isn’t secured by the second residence, the interest paid would not be residential housing interest. Interest with respect to $100,000 would be home equity interest and interest for the second $100,000 would be non-deductible personal interest. If you later refinanced the second residence and used the proceeds to pay off $200,000 of the mortgage on the principal residence, interest on the new mortgage would be tax deductible as residential housing interest because it would be funds used to purchase the residence and secured by that residence.

Refinancing rental properties

What happens when you refinance a rental property and use the cash elsewhere? This is commonly done as a way to get "tax-free" cash without selling a property.

You are supposed to trace how the funds are used and deduct the interest accordingly.

For example, you refinance property A for a new $500,000 mortgage. $300,000 of the proceeds is used to pay off the original acquisition mortgage. $100,000 is used to buy rental property B. $100,000 is used to remodel your principal residence. 60% of the interest is deductible on Schedule E for property A. 20% of the interest is deductible on Schedule E for property B. Since the mortgage isn’t secured by the principal residence or a second residence, 20% of the interest attributable to remodeling your principal residence is non-deductible personal interest.

Refinancing through passthrough entities

Accounting can get even more complicated when properties are refinanced through passthrough entities. When the loan proceeds are passed through as distributions to partners or S corporation shareholders, the interest is separately reported and each partner or shareholder is required to allocate the interest according to how the funds were used. You should definitely get professional help when applying the rules for passthrough entities. Even better – avoid making loans to make distributions to partners or shareholders.

With the combination of the explosions of investments in real estate and refinancing of real estate, accounting for mortgage interest will become a big tax audit issue. Avoid having a big bill for taxes due plus interest and penalties by making the effort to correctly report your interest deductions on your income tax returns. Get professional help.

For more articles and information about new tax real estate tax developments, visit our Real Estate Investor Tax Articles or Frequently Asked Questions and subscribe to our newsletter, Michael Gray, CPA's Real Estate Tax Letter.

Michael Gray, CPA
2482 Wooding Ct.
San Jose, CA 95128
(408) 918-3162
FAX: (408) 938-0610
Hours: 8am - 5pm PDT Monday - Friday

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