When is investment loan interest not tax deductible?

Question

I'm not sure what my options are... I just bought a $171K SFH, rental-A, using 75% mortgage and 25% cash down. I spent $18k fixing up rental-A, rented it, and am getting good cash flow.  I'd like to pay myself back the 25% down and the $18K. I have a $200K SFH rental which is debt-free, rental-B. I also have a 401k I can borrow up to $50K from. What are my best options? Should I:

1) Cash-out refi rental-B to repay myself? Should I get a little extra (higher LTV) for the next investment? Will the interest be deductible?
2) Take a $50k loan against my 401k and settle for getting most of my money recouped? Is the interest deductible?
3) Should I get a HELOC on rental-B to repay myself? Then have the HELOC for future investment opportunities? Is this deductible?
4) Would it be better if I used a corporation in the future? Does that make all the above debt deductible?

Holly Chan · Answer

1. Tracing the debt proceeds is time sensitive so the deductibility of the interest expense will depend on what you use the proceeds for after you receive them. If the rentals and loan are in an entity, there is an optional tracing rule which would allow for the proceeds to be allocated toward Rental-A. This all needs to happen within the same calendar year.

2. If any of the 401(k) loan proceeds are in any way linked to the elective contributions, the interest is not deductible. Borrowing against a plan which is secured by any elective contributions at all will result in non-deductible interest. In other words, you can't pick and choose which funds you're borrowing against - they're all part of the same plan.

Holly Chan · Answer

Deductibility of the interest expense in option 1 or 3 will depend on what you use the funds for. If you invest them into another property (such as fixing up rental-B or buying rental-C), it will be deductible for that property. If you use it for any personal expenses it will not be deductible.

Interest on a loan from a 401k plan which is secured by elective contributions is never deductible. If it's secured by a residence or other asset completely separate from elective contributions, it might be deductible depending what the funds are used for.

Corporations are generally not well suited for rentals from a tax perspective. Putting them into an LLC might change the deductibility of the interest but it still depends on how much of the proceeds are used within the LLC versus distributed out. If enough is distributed out of the LLC, deductibility will still depend on what the funds were then used for (personal interest is not deductible). The key difference with it being within an LLC is timing on tracing the use of funds, which could make it easier to get deductible interest. You should definitely consult with your CPA if this is the direction you're considering.

Ashish Acharya · Answer

• From a tax perspective, the activity determines the deductibility, not the underlying assets. If the activity is business/investment-related, the interest will/might be deductible.
• Cashing out to pay yourself will be personal in nature and will not be deductible. 
• You can achieve the same deductibility without the corporations as well.

Joe Splitrock · Answer

As others said, deductibility follows use. The $18K rehab costs would be added to basis for depreciation, assuming you did the improvements before you rented the property. You should be able to deduct interest anything up to 100% of the purchase price and improvements. For example if you paid $171,000 and improved it $18,000 the total is $189,000 which would be 100% financed. If you refinanced the property at $200,000 that would be $11,000 over the investment. The interest on that $11,000 portion would not be deductible, so that means 5.5% of the interest is not deductible against that property. If you took that $11,000 and used it as a down payment on another property, you could deduct the interest against the new property. If you used the $11,000 for a vacation, the interest would not be deductible.

It doesn't matter what property secures the loan, but rather what the use of the money is.

Jody Sperling · Answer

3. HELOC. I'm not a CPA giving financial advice, but in my experience the interest is tax deductible. Lines of credit used to buy assets are the best form of money in existence. You aren't charged interest on money you don't use, and you can repay the money you use as quickly as you like and see immediate results in reduction of interest payments.

Richard Brightwell · Answer

Thank you @Holly Chan!!!

Richard Brightwell · Answer

Great nuggets of info! Thank you all for the help! I think I need to provide a few extra details and ask a couple of clarifying questions.

Rental-A was purchased in March of this year. The $43K down payment and $18K fix-up were paid out of my checking account back in March/April. Based upon @Joe Splitrock's answer, the IRS would have let me borrow those amounts (debt on Rental-B) and it would be tax deductible, all totaling $189K. I wasn't smart enough to do that in March/April. Is it too late to borrow now and characterize it as some kind of delayed financing?

I did take a 401K loan in February for $42K for an unrelated personal reason, just weeks before putting the $43K down on the mortgage. My employer has contributed $17.5K to my 401k. I think I read somewhere that borrowing against employer contributions (not my elective contributions) could be tax deductible? @Holly Chan am I remembering correctly? If so, could I ethically characterize $17.5K of my loan as being used for the purchase of Rental-A or is it too late? Is it just a matter of what I was thinking at the time, which would seem rather punitive?

I wish I'd thought of all this back at the time and planned better.  Lesson learned.

When is investment loan interest not tax deductible?

Most Popular Reply