Refinanced interest - is it tax-deductible?

Question

This post is meant for my accounting colleagues - an invitation to debate, basically.

Let's consider scenarios.

1. (clear) You buy a rental with a $100k loan. Two years later, you refi into a new $100k loan with better terms. Is the interest on the second loan deductible against this rental? Yes, nothing to debate.

2. (clear) You buy a rental for $100k which needs $20k in repairs. You get a hard money loan for $120k. After rehab, you refi into a permanent $120k loan and start renting it. Is the interest on the permanent loan deductible against this rental? Yes, nothing to debate.

3. (clear) You buy a ready-to-rent rental with a $100k loan. Two years later, you refi into a new $120k loan, pulling out $20k equity in cash. Is the interest on the second loan deductible against this rental? Partially yes, albeit the "partially" thing is an unpleasant surprise to most investors. The interest on $100k of the $120k is deductible. The interest on the remaining $20k is not, unless this $20k is used to rehab this property.

3a. If the $20k is used to buy another property, it could be deductible against that new property, requiring that you comply with interest tracing rules. Basically, keep this $20k separate from all other money and show that it was specifically applied to the closing or rehab on the new property.

And now we start getting into gray area.

4. (almost clear) You borrow $100k from your parents, unsecured, and use it to buy a ready-to-rent rental. 6 months later, you get a mortgage for $100k and pay your parents back. Is the interest on both the unsecured parents loan and the mortgage deductible against this rental? Looks like a yes to me. As far as I can tell, unlike with personal Schedule A mortgage interest, there is no requirement that the loan is secured by the property.

5. (almost clear) You buy a rental for $100k which needs $20k in repairs. You get a private loan for $100k and charge $20k for rehab on your business credit cards. After the rehab, you refi into a permanent $120k loan and start renting it. From the new loan, you pay off the initial loan and the credit cards. Is the interest on the permanent $120k loan deductible against this rental? Looks like a yes to me.

Finally - drum roll! - the really grey area.

6. (unclear) You buy a ready-to-rent rental for $100k cash. 6 months later, you get a mortgage for $100k. Is the interest on the loan deductible against this rental?

7. (unclear) You buy a rental for $100k which needs $20k in repairs. You get a private loan for $100k and pay $20k cash for rehab. After the rehab, you refi into a permanent $120k loan and start renting it. Is the interest on the permanent $120k loan deductible against this rental?

My initial thoughts on #6 and #7.

This is business interest, not home mortgage interest. So we do not really have to consider the acquisition indebtedness concept here, do we? All we have to ensure is that the proceeds are used for business purposes. Refinancing a loan that was initially used for business purposes (purchase/rehab) seems to fit the bill, including private unsecured loans and credit cards. With proper tracing, of course.

Where I'm driving myself crazy is when cash enters the picture. If I have an LLC, and I formally loan my personal cash to my LLC (promissory note and all that) - that seems to work just fine. What if I do not have an LLC and do not have any documented lending?

Matt Ward · Answer

@Michael Plaks @Eamonn McElroy As usual I browse BP for tax forums and am staying up later than I should. I think Pubs 527 & 535 are helpful here... When you refi a rental for a higher amount than the initial balance, the amount over the initial balance is not deductible. So in a BRRR strategy where you buy all cash and refi later, that refi interest is not an expense on that property. Now if you use that refi equity to fund another property, then the Interest may be an expense on the property to which it is allocable to. And so on and so on... Love me some interest tracing talk! Disclaimer, it’s late and I may actually be asleep as I write this so please do correct me :)

Eamonn McElroy · Answer

@Michael Plaks "If you borrow money on Day 1 - you have a clear deductibility. But if you temporarily finance with your own cash - it seems to kill the interest deduction."Agree. The interest tracing rules make things "interesting" (read: often unfavorable, always complex)."I just wish that there was a clean legal way to self-borrow without losing the interest deduction on future refi."If the taxpayer has a wholly owned C Corp or S Corp, it might be advisable to draw up bonafide loan and lend to the individual/SMLLC at the AFR for property purchase. Refi the property with a 3rd party lender and pay back the loan. Shouldn't have any issues under Treas Reg §1.163-8T(e)(1) above."Yet, I struggle to accept that a short-term cash infusion creates such dramatic tax disadvantage, as opposed to immediate financing (which is often impossible or impractical to obtain.)"Yup...but until I see authoritative guidance suggesting otherwise -- IRC, Treas Regs, Rev Proc, Rev Ruling, Tax Court Case... I think Treas Reg §1.163-8T speaks for itself.Unfair? Maybe. Unduly complex? Yes, but we are talking about tax law. Always done correctly? Absolutely not. Can we assume DIY turbo tax users are tracing debt proceeds?I heard a story a couple of years ago about a lady who cash out refi'ed $100k out of a free and clear rental around 2004 for personal expenses. She's been writing off the interest ever since on Sch E.How about this....taxpayer walks into the bank with the $100k. He deposits said money into an account and agrees with bank that it will be used as collateral for a $100k personal loan. The loan is executed, $100k of proceeds are disbursed to taxpayer who immediately buys the property with it same day. Shortly after, he refinances the property with a 3rd party and uses the $100k proceeds from the new mortgage to extinguish the bank personal loan. He withdraws his $100k cash from the bank account and walks away. Have we (potentially) solved the problem?

Eamonn McElroy · Answer

@Michael Plaks "Where I'm driving myself crazy is when cash enters the picture. If I have an LLC, and I formally loan my personal cash to my LLC (promissory note and all that) - that seems to work just fine. What if I do not have an LLC and do not have any documented lending?"What if you have a SMLLC disregarded for tax purposes? Would a loan to the LLC be respected in that situation?Especially considering the potential for abuse? (e.g. you could income strip from Sch C to Sch B and avoid SE taxes) Effectively you'd be loaning yourself money (i.e. from one pocket to the other).Bonus points for authoritative citation.

Eamonn McElroy · Answer

@Michael Plaks I'll take a stab Michael...Number 5 may have a wrinkle if a personal CC was used that had a balance beyond $20k, some or all of which is non-business debt. I assume, since a business CC was used, the entire balance is business related. See Treas Reg §1.163-8T(e)(1) below, and take into consideration the ordering rules for payback of debt.For number 6 and number 7, I'd want to know what happens to the $100k cash (number 6) and the $20k cash (number 7) that taxpayer gets from the bank upon execution of the loan. The answers to those questions should tell us how we need to treat the loan interest.If taxpayer just throws it in a bank account, the regs are pretty clear it is investment interest, which as you well know is itemized and limited to investment income.In a nutshell, we need to trace the cash.Treas Reg §1.163-8T(a)(3) Manner of allocationIn general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures.Treas Reg §1.163-8T(a)(4)Treatment of interest expense(i)General ruleExcept as otherwise provided in paragraph (m) of this section (relating to limitations on interest expense other than the passive loss and nonbusiness interest limitations), interest expense allocated under the rules of this section is treated in the following manner:(A) Interest expense allocated to a trade or business expenditure (as defined in paragraph (b)(7) of this section) is taken into account under section 163(h)(2)(A);(B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates;(C) Interest expense allocated to an investment expenditure (as defined in paragraph (b)(3) of this section) is treated for purposes of section 163(d) as investment interest;(D) Interest expense allocated to a personal expenditure (as defined in paragraph (b)(5) of this section) is treated for purposes of section 163(h) as personal interest; and(E) Interest expense allocated to a portfolio expenditure (as defined in paragraph (b)(6) of this section) is treated for purposes of section 469(e)(2)(B)(ii) as interest expense described in section 469(e)(1)(A)(i)(III).Treas Reg §1.163-8T(c)(4)Allocation of debt; proceeds deposited in borrower's account(i)Treatment of depositFor purposes of this section, a deposit of debt proceeds in an account is treated as an investment expenditure, and amounts held in an account (whether or not interest bearing) are treated as property held for investment. Debt allocated to an account under this paragraph (c)(4)(i) must be reallocated as required by paragraph (j) of this section whenever debt proceeds held in the account are used for another expenditure. This paragraph (c)(4) provides rules for determining when debt proceeds are expended from the account. The following example illustrates the principles of this paragraph (c)(4)(i):Example. Taxpayer C, a calendar year taxpayer, borrows $100,000 on January 1 and immediately uses the proceeds to open a noninterest-bearing checking account. No other amounts are deposited in the account during the year, and no portion of the principal amount of the debt is repaid during the year. On April 1, C uses $20,000 of the debt proceeds held in the account for a passive activity expenditure. On September 1, C uses an additional $40,000 of the debt proceeds held in the account for a personal expenditure. Under this paragraph (c)(4)(i), from January 1 through March 31 the entire $100,000 debt is allocated to an investment expenditure for the account. From April 1 through August 31, $20,000 of the debt is allocated to the passive activity expenditure, and $80,000 of the debt is allocated to the investment expenditure for the account. From September 1 through December 31, $40,000 of the debt is allocated to the personal expenditure, $20,000 is allocated to the passive activity expenditure, and $40,000 is allocated to an investment expenditure for the account.Treas Reg §1.163-8T(e)Debt refinancings(1)In generalTo the extent proceeds of any debt (the "replacement debt") are used to repay any portion of a debt, the replacement debt is allocated to the expenditures to which the repaid debt was allocated. The amount of replacement debt allocated to any such expenditure is equal to the amount of debt allocated to such expenditure that was repaid with proceeds of the replacement debt. To the extent proceeds of the replacement debt are used for expenditures other than repayment of a debt, the replacement debt is allocated to expenditures in accordance with the rules of this section.

Michael Plaks · Answer

Funny you. Trying to apply logic to tax law. Ha.

Ashish Acharya · Answer

Finally getting to this. Looks like there is one more reason to get a LLC so that a cash investors can treat the cash as a contribution to the LLC first and buy the property. Then, later take out the cash as distribution.This way, The refi mortgage interest is still deductible. I thought the exact same thing : such a disadvantage for the short term personal cash use. I have personally done the same and have regretted since then.What do you think about this logic. -The new equity refi debt is secured by the house and if the debt is not there, there will be be no income. If defaulted on a loan, the house is gone. Thus, the interests is business related and deductible against the rental income. The interest is income to bank, and it should be deductible somewhere.The cash that is taken out as equity refi will make the investor whole, just as distribution or return of capital.

Ashish Acharya · Answer

Finally getting to this. Looks like there is one more reason to get a LLC so that a cash investors can treat the cash as a contribution to the LLC first and buy the property. Then, later take out the cash as distribution.This way, The refi mortgage interest is still deductible. I thought the exact same thing : such a disadvantage for the short term personal cash use. I have personally done the same and have regretted since then.What do you think about this logic. -The new equity refi debt is secured by the house and if the debt is not there, there will be be no income. If defaulted on a loan, the house is gone. Thus, the interests is business related and deductible against the rental income. The interest is income to bank, and it should be deductible somewhere.The cash that is taken out as equity refi will make the investor whole, just as distribution or return of capital.

Eamonn McElroy · Answer

@Matt Ward Agree Matt, the loan principal proceeds must be traced and interest allocated accordingly. It gets more complicated if taxpayer used the proceeds for multiple "buckets". e.g. Refi a rental with a current $100k balance loan on it for $200k. Use $50k of the $100k cash out for a new personal car and clothing, put the other $50k in a savings account. Now we have to track the repayments too...

Michael Plaks · Answer

Yes, that sounds like another way to structure self-borrowing, besides a bona fide loan to a controlled entity.We should not have to play those games though. But I know I'm preaching to the choir.

Michael Plaks · Answer

I'm trying to think logically. Yeah, I realize how ridiculous it sounds when talking tax law. :)If you borrow money on Day 1 - you have a clear deductibility. But if you temporarily finance with your own cash - it seems to kill the interest deduction. Which sounds - dare I mention the word - unfair?We can try to work around the problem by formalizing borrowing, as I suggested. I have no idea whether a disregarded entity can work or not. Did not try to research precedents.I just wish that there was a clean legal way to self-borrow without losing the interest deduction on future refi.I understand the legislative intent in disallowing interest deduction for equity refi. And when you initially bought with cash, you have 100% equity, so any refi is technically an equity pullout. Yet, I struggle to accept that a short-term cash infusion creates such dramatic tax disadvantage, as opposed to immediate financing (which is often impossible or impractical to obtain.)