Mortgage rental property or primary residence?

[Bryan Johnson]

In the simplest case of an investor with a single primary residence and a single rental property, where one of the properties is owned free and clear, and the other is mortgaged, in terms of tax benefits, does it matter which property is mortgaged?  If so, why?  I'm assuming house values and mortgage rates on either property are identical, equity is more than 30% on mortgaged property, and mortgage is under the $1M IRS limit for primary residence deduction in this hypothetical case.

[Don Konipol]

There are two different scenarios, leading to two different answers.

I the rental property goes vacant for a period of time, the expenses may be in excess of rental income, and the amount in excess of expenses may not be able to be utilized as a deduction in certain circumstances.  Interest on a $1M or less loan secure by a primary residence, and sometimes secondary residence as well, is always deductible.  So, in this circumstances you would want the loan on the personal residence.

Some states have unlimited, or very high homestead protection.  So, if you are in or ind yourself in financial trouble in the future, having a free and clear personal residence will allow you to exclude this amount from any creditor action, and even keep the value of the equity while other debts are discharged through BK (in some states).  This is not true of equity in rental property.  So in this case we arrive at the opposite answer - we want the loan on the rental and the personal home free of debt.