Refinanced interest - is it tax-deductible?

[Michael Plaks]

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?

[Eamonn McElroy]

@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 allocation

In 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 rule

Except 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 deposit

For 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 general

To 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.