tax deductible interest - yes or no?

Question

Hi,
I'm getting conflicting advice from two CPAs and was wondering if anyone cares to chime in. Here is the situation. My primary residence is paid off and I want to tap into the equity in order to acquire rental real estate. I'm subject to AMT provisions clawing back regular mortgage (and HELOC) interest deductions. One CPA tells me that if I tap my HELOC for INVESTMENT purposes, then I will be able to deduct the interest as long as I comply with certain tracing rules set forth by the IRS. My other CPA says that it doesn't matter what I use the cash for - what matters for tax (ATM clawback) purposes is the collateral, which in my case is the primary residence and therefore, that interest would NOT be deductible for me.
Who is right?
Thanks for any insights into this rather puzzling (to me) issue!

Dave Toelkes · Answer

A Spalten I wonder how it is to your advantage to draw against your HELOC just to earn interest in your checking account until you have a use for the funds. You will pay interest (from the day of the draw) on the amount withdrawn from the HELOC at a rate which will most likely be some huge multiple of the rate you are earning in your checking account. Why pay interest on loan funds you won't use for awhile?

Steven Hamilton II · Answer

A Spalten, Yes, you could deduct the interest on Schedule E as long as you follow the tracing rules. -Steven

Steven Hamilton II · Answer

You would have to be able to specifically trace what was used to the loan. Look up interest tracing.

Michael L. Christensen · Answer

A few years ago, I took out a first mortgage on my personal resident to buy some rental properties. I did not deduct my interest on my Sch. E because I didn't know it was possible. I instead took the normal mortgage deduction on Sch A. which is not as good tax wise. Now that I know it is legal, can I take the mortgage interest deduction on my Sch E. this year even though I didn't in the past?

Roy N. · Answer

In Canada, we have a similar procedure is known as "The Smith Manoeuvre" (after Frasier Smith) whereby you convert non tax deductible debt (i.e. mortgage interest on your primary residence) to tax deductible debt (i.e. interest payments on monies borrowed to earn investment income. The idea is that you pull equity out of your primary residence via a HELOC and invest it (rental property, stocks, etc). You continue to service your mortgage as per normal and use the proceeds of your investing (net income from rent, dividends, etc), and any tax refund arising from the deductible interest expenses, to pay down your residential mortgage. When you pay down your mortgage, you turn-around, pull out the principle and re-invest it. Rince & repeat. ... but be cautious not to step outside the lines which the CRA considers reasonable, lest they deny your manoeuvre, leaving you with a undesirably large tax bill. Of course ... for those who have the ability to deduct mortgage interest already, such a move process would be of little use given the risks :)

Andrew S. · Answer

It's about seasoning the funds. If I want to get a mortgage (using the HELOC funds for downpayment), I don't think my lender would accept cash coming straight from HELOC as "seasoned"?

Steven Hamilton II · Answer

A Spalten, As long as you can trace where those funds went easily it should not be a problem. You can show it being deposited and then used for the purchase in a reasonable amount of time. As in not sitting there for 6 months before you invested it into a property. -Steven

Andrew S. · Answer

Thanks Toby - just one more double-check on the practical aspects of the tracing rules. What is the basic principle that these rules demand? Let's say I transfer 100K of my HELOC funds to my checking account and then a few months later, I write a check to purchase an all-cas property for 80K and another check for 20K to put an new roof on one of my rental properties. Will the fact that I can document the original transfer of the 100K out of HELOC into checking and then the two transactions that are clearly RE investment related be sufficient to demonstrate "tracing"? Or is this more complicated?

Toby Johnston · Answer

If it helps at all, I am also a CPA and I agree on the interest tracing. Should be deductible on Schedule E against the rental income.

Andrew S. · Answer

Thanks much! So, sounds like the move via an interest-bearing checking account is a viable option as long as it is clearly tracked. I'll stay on the conservative side and will draw the funds for closing as a cashier's check straight from the HELOC (my bank lets me do that, I believe), but it is good to know that I CAN go through a checking account, if necessary. Thanks again for the input - I'm new here and this forum rocks! I wish I had found it a long time ago!