How Can I Get Schedule E Mortgage Interest Deduction On Refi?
For the last three years I have been using my credit card money to invest in cheap property. I had just become unemployed, so I had decided to wait until I got another job before mortgaging any property. The land was all auction-cheap and I hold it fee simple.
To complicate things, I wasn’t thinking about the flow of the money and I mostly deposited the money into my personal account since I was also using the credit card money for some living expenses. The cash flow from my rental properties was not enough by itself to keep me in the black. My limited 401K money also disappeared into that account.
Thus, all the credit card money first went into a general checking account used to pay personal bills. It then may have gone to the stock market, money markets, cds, etc, before being cashed out to buy the land. (I do have a separate checking account for my rental properties.)
I finally realized that getting a job in my specialty was very unlikely at my age, so I obtained a zero-income mortgage on a recently paid-off rental property. (The mortgage money is waiting in a separate savings account.)
Am I correct in thinking that I can’t deduct the Schedule E mortgage interest if I pay off the credit cards because the commingling of funds makes all the credit card debt appear as personal debt?
IRS PUB 527 states:
Interest expense. You can deduct mortgage interest you pay on your rental property. Chapter 5 of Publication 535 explains mortgage interest in detail.
IRS PUB 535 states:
Allocation of Interest: In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.
I don’t see how I can allocate the loan proceeds to the past-purchase of the investment property if I just pay off the credit cards.
Would it be better to fund a LLC (taxed as a Sole-Proprietor) with the mortgage funds, and use the LLC funds to buy the property from myself? (Is this legal/proper?) I could then use the cash to pay off the credit cards. I might have to pay some capital gains tax on the property, but that would be little compared to what I would save by deducting all that interest.
If I can get away with this, do I deduct the interest against the Schedule E mortgage interest for the rental property, which would still be held in my name?
Generally speaking, a cash out refinance of investment property is treated the same for tax purposes as your original purchase money mortgage. If you cashout more than $100K, then you have to deal with limits on the amount of deductible interest.
If you are not subject to the $100K limitation, you are free to spend the loan proceeds any way wish and may still deduct all the loan interest with one exception that I am aware of. If any of the loan proceeds are used to purchase tax-free investments, then you may not deduct the interest on that portion of the loan proceeds. Does not sound as if this circumstance applies to your situation.
Thanks for the reply, NewKidinTown, but I thought the $100K limitation applied to Home Mortgage Interest Deduction, requiring the loan to be made on your first or second home. Since this is an investment property I didn’t think the rules or limitations applying Home Mortgage Interest Deduction (IRS PUB 936) had anything to do with investment property interest deduction. If I am mistaken, please refer me to IRS publication indicating the $100K investment interest limitation.
bizboy
NewKidinTown,
Concerning the $100K limitation, were you talking about this?: Taxpayers with adjusted gross income of $100,000 or less may be eligible to deduct up to $25,000 of passive losses a year against salary and portfolio (investment) income.
Which makes sense.
Do you know where the tax code addresses the issue of deducting mortgage interest on residential rentals without regards to allocation?
bizboy
I think he may have been speaking about the $100K limit on home equity loans. That is, you can only deduct the interest on 100K or less. I am not sure what this would have to do with the rental property as this is for primary residences.
On rental property you can deduct any and all interest of loans that are secured by the building. You can even deduct interest on loans that are not secured by the building as long as you can prove (and have a paper trail) showing that the loan proceeds were used for the building.
Hi bizboy:
Where in the heck is Puposky, Mn? What types of RE investments do you have going and how long have you been at it? I live just north of St. Paul but my properties are near the Fargo - Moorhead area.
Quote:
On 2004-08-12 16:41, jspaeth wrote:
Hi bizboy:
Where in the heck is Puposky, Mn? What types of RE investments do you have going and how long have you been at it? I live just north of St. Paul but my properties are near the Fargo - Moorhead area.
Hi Jspaeth,
Puposky, MN is a almost nonexistant town about 20 miles north of Bemidji, MN (Home of the famous Paul and Babe Statues) Property up here is still pretty cheap but the winters (and summers, this year) are cold. I've been in the rental market for about 15 years. How about yourself?
Back on topic, I called the IRS and got a response: I could spend the money from my residential rental property mortgage on anything and still deduct the interest. When I asked for a reference in the code, she couldn't provide me with anything. I think I will call them a couple more times and see if the responses are consistent.
I also went to a CPA yesterday and he thought that I would have to allocate the money to investment in order to expense the interest, and then he wasn't sure if I could expense it on the schedule E or what.
So the question still stands:
Is the interest from a new mortgage on a residential rental property completely deductible on schedule E, no matter where I spend the money?
Surely many people have experienced this situation. Do they just deduct the interest and hope for the best?
Thanks,
bizboy
Maybe I'm missing something here. So, you refinanced a rental, and pulled cash out. And your question is, can I spend the money wherever you want, and still deduct the interest from your taxes? I'd say, yes you can, because the money you pulled out is just ordinary debt. It doesn't MATTER where the money went you pulled out, you just went further in debt. I've done this several times, as a matter of fact. Why would they care where the money goes, you're still paying interest on an investment property.
Quote:
On 2004-08-13 13:31, jam200 wrote:
Maybe I'm missing something here. So, you refinanced a rental, and pulled cash out. And your question is, can I spend the money wherever you want, and still deduct the interest from your taxes? I'd say, yes you can, because the money you pulled out is just ordinary debt. It doesn't MATTER where the money went you pulled out, you just went further in debt. I've done this several times, as a matter of fact. Why would they care where the money goes, you're still paying interest on an investment property.
Thanks for the reply, Jam200,
You have pretty much got the question right, and I think that generally speaking most people just go ahead and deduct the interest expense on their schedule E, but I don't think it's correct. There are many cases where the IRS are strict in deducting interest, say the Home Mortgage Interest Deduction, for example. Also any interest that comes from personal expenditures, like credit card interest, car loan interest, etc. Yes you went further in debt, which the IRS doesn't really care about, but deducting the interest means you are shrinking their share of the booty and that is something the IRS is concerned about.
Also, concerning business interest deduction, any interest deducted also has to be spent on business, investment, etc. and not on personal expenses in order to be deductible. I don't really want to use a business deduction of the interest. I would really like to just deduct it from the schedule E for this rental property.
So is the consensus of this forum that you can just deduct the interest on schedule E and hope you aren’t audited?
What does DaveT, JohnLocke, and the rest of the regulars have to say about this?
Thanks,
bizboy
Hi bizboy:
It is perfectly legal to use the proceeds of the loan on anything you want to spend it on and deduct the full interest. You should keep in mind, though, that your basis in the property does not change even through you would now owe more on the property. So, in other words, when you go to sell at some future date, you could be in a situation where you would not have enough money to pay off the mortgage(s) and capital gains tax (assuming you do not 1031 exchange) from the proceeds on the sale of the rental.
This type of scenerio is a strategy for some investors. What they do is, about every 5-years, refinance their properties for the max and use the proceeds to live on tax free. This way, the properties generally show a loss (since they are fully mortgaged/ have high interest expense) so they have no rental income tax either. But as I said, it will catch up to you some-day when you need to sell (since your basis will continue to go down yet your loan amount keeps going up).
I am very familiar with Bemidji. In fact, I used to work for Northwest Technical College, and would have meetings on the Bemidji campus at least once a week. I am now living just north of St. Paul but my rental property is in the Fargo-Moorhead area. I have a partner who lives there. We have one 4-plex and a commercial lot that we plan to build a 12-18 plex on.
Hi Jspaeth,
Thanks for the response, but I think I have finally gotten some professional answers. Unfortunately, they contradict your advice. You might check with your CPA, I would love to find out the Pros I talked to are wrong.
Bemidji almost had a frost last night. The old joke may be true, “We only have two seasons up here, Winter and July 4th!”
The Bemidji area is really growing; have you been up here recently? And property values have climbed enormously for the last couple of years. Are they moving up as much in Fargo?
bizboy
I talked to another CPA, he told me that the mortgage INTEREST had to be allocated as to how the money was spent. The money can be spent on anything, but if you want to deduct the INTEREST it has to be spent on business, investment, etc. and traceable.
The second CPA backed up basically the same thing with his tax research service. His question to the research service:
Circumstances: A taxpayer has a residential rental property, the activity which is reported on his Schedule E. This property has been owned for a many years and no longer has a mortgage. The taxpayer than takes out a mortgage on the rental property. The collateral on the mortgage is the rental property. The proceeds of the mortgage are spent on buying raw land as an investment.
The land will not be rented out and no buildings will be constructed. Question: Is the interest paid on the mortgage deductible on the Schedule E of the involved rental property or is it investment interest reportable on Schedule A.
Answer: The interest will be traced to the debt proceeds. In this case, the interest would be deducted as investment interest on Schedule A. More information can be found on this topic in IRS pub. 535, Chapter 5.
I also went to a seminar on 1031 exchanges last night and the speaker (not a CPA, but experienced in real estate taxation) also said that the mortgage money has to be reinvested for the INTEREST to be deducted.
Oh, and look, an answer from the IRS just showed up:
My question to the IRS was:
I purchased a residential rental property 15 years ago, using to a $17,000 mortgage. I paid off the $17,000 mortgage on the rental property.
Can I deduct all the mortgage interest from a new $40,000 mortgage on the residential rental property using Schedule E, no matter what the proceeds are spent on?
The Answer To Your Question Is:
Thank you for using our service. I apologize for the delay in responding. If the proceeds of the loan are not spent on the rental property, then you cannot deduct the interest as a rental expense. The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, investment, or passive activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan’s proceeds. Allocate your interest expense to the following categories.
Trade or business interest
Passive activity interest
Investment interest
Portfolio interest
Personal interest.
In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.
Example. You secure a loan with property used in your business. You use the loan proceeds to buy an automobile for personal use. You must allocate interest expense on the loan to personal use (purchase of the automobile) even though the loan is secured by business property.
"Proceeds not disbursed to borrower" Even if the lender disburses the loan proceeds to a third party, the allocation of the loan is still based on your use of the funds. This applies whether you pay for property, services, or anything else by incurring a loan, or you take property subject to a debt.
"Proceeds deposited in borrower’s account" Treat loan proceeds deposited in an account as property held for investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest expense. If you withdraw the proceeds of the loan, you must reallocate the loan based on the use of the funds. For additional information see the Publication 535, Business Expenses. I hope this information is helpful.
So the final answer: To get the maximum interest deduction on that rental property’s Schedule E, you have to spend all the mortgage money on that rental property.
If I invest it, it goes on Schedule A. If I have no offsetting business gains, then I lose the interest deduction.
If I invest it all in another rental property, I deduct it from that rental property’s Schedule E.
More than likely I will have to allocate it to different things and deduct it or not in various ways.
I think that most people just take the interest deduction on their Schedule E and hope they don’t get audited. From all my discussions and research it seems obvious the IRS is very restrictive on allowing deductions of INTEREST. Even the Home Mortgage Interest deduction is pretty restrictive.
bizboy
Wow!
Normally, I would say that interpretation of the tax code could lead to varying opinions. However, I find that your questions to the IRS and their response to be very clear.
I cannot believe their response and have been told by multiple CPA’s that this is perfectly legal to do so. It also just doesn’t make any sense to me.
Consider this example: Jon Doe works a W2 job for many years and saves some money. Jon takes his savings and purchases an apartment complex. He pays cash for it because the seller cannot wait for a purchaser to get a loan. Once Jon takes possession of the building, he goes to the bank and secures a mortgage on the building. The bank issues him a check for the amount of the loan. Jon later uses this money to purchases cars and other personal items.
Now, according to that IRS response, Jon will never be able to deduct interest expense on this building because he used the proceeds (money he already had, really) to purchase personal items???. It just doesn’t add up for me…how about for you?
I think that the IRS looks at the transactions within a period of time (probably a tax year) to see where the money comes from and where it goes. My conservative CPA thought that I could deduct the interest on Schedule A if I track the money back to credit card purchases of investment real estate. The credit card balances would be paid off with the new mortgage money. In other words, I borrowed money from an account 2 years ago and bought some land, I now am borrowing more money on the rental investment property and I am paying off those old loans.
Also, I think that there is a question of the basis left on the investment property. If I still have $10K depreciation left, meaning I have $10K basis in the structure, I should be able to deduct the interest on that.
That’s why in your example I think Jon could deduct all the interest because his basis is so high and both transactions were closely timed.
Lets say that Jon refinances his mortgage in 2 years. He can pull another $30K out because he’s a good investor. I think the IRS looks at that and says, “You can’t deduct the interest for that $30K unless you spend it on an investment.”
In other words, I think the IRS is simply stating that for investment interest to be deductible (Schedule A or E interest not Home Mortgage Interest) it has to be on money spent on investment. Since this can be a very tangled area, with an incredible range of possible scenarios, I don’t think the IRS looks at this area much, probably only on the random audits or if you’re audited for something else. Unfortunately, I am not much of a risk taker when it comes to the IRS, so I will just have to figure out a way around it all so that I can deduct ALL the interest per IRS rules.