Deducting Interest When You Refi to Buy a Rental

Dear Tax Talk, I plan to borrow against my primary residence to buy a rental property. I owe $70,000 on my property and will refinance for $250,000 (I will not live in the rental). I will pay cash for the rental property from the equity in my primary residence.

My questions are:

1. Will I be able to deduct all the interest from refinancing my home?

2. Is it possible to allocate part of the interest to the rental property and apply it against rental income, along with depreciation and expenses?

Thanks. -- James

Dear James, I thought the days of banks lending against your home for investment property were gone. You must know a good banker. Assuming your banker goes along with it, you have a couple of options in deducting the interest on the refi proceeds. Generally you will be able to claim all the interest you pay. Some of it can be treated as home mortgage interest and deducted on Schedule A, or you can choose to deduct all of it on Schedule E against the rental income.

You can borrow up to $100,000 from your home for any purpose and claim the interest on Schedule A. You can also continue to claim the interest on the pre-refi original balance of the mortgage on Schedule A.

Since you're contemplating borrowing $180,000, the interest on the remaining $80,000 in debt will be claimed on Schedule E. You'll have to clearly show that the remaining $80,000 was used to purchase the rental property under the IRS' tracing rules for interest deductions. For example, if the bank disburses the full $180,000 to close on the rental property, the proceeds can be directly traced to the rental property. If the $180,000 is deposited into a separate bank account and then used to close on the property, the tracing is fairly straightforward. Complications in tracing would arise if you commingle the funds with other accounts you may have so as to obscure the tracing of the proceeds to the rental property.

Since losses from rental activities can be limited to income, it may make sense to claim up to $100,000 in interest as an itemized deduction, thus minimizing any rental losses you have. For example, if you pay $25,000 in interest on the new $250,000 mortgage, $170,000 of the mortgage is assigned to Schedule A and $80,000 is assigned to Schedule E. Then $17,000 of the $25,000 in total interest paid would be claimed on Schedule A and $8,000 on Schedule E.

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