Discussion:What happens to interest deduction on personal residence home equity loan proceeds which are used to buy a new personal residence?

I reckon all TP can do is wait until he has enough equity in the new home to get an LOC secured by it, and use the proceeds to pay off the LOC secured by the old residence which is now a rental property.

This must happen all the time. Am I seeing this right? Are there any loopholes I am missing to get that interest deducted somewhere?

Hypothetically speaking, I moved out of a house and decided to convert it to rental property. In addition, I wanted to take the equity out of that property. I would secure a mortgage on that property. Whether I treated it as residential real estate or placed in Sub S I don't see why the mortgage interest could'nt be deductible against my rental income. What is done with the proceeds from the loan are not relevent. This is merely leveraging a property.

I'm not quite sure what LOC means. Letter of Credit or Line of Credit. I assumed since it was secured by the personal residence it was in essence a home equity loan and therefore deductible. (Albeit the proceeds did'nt go into the 1st residence.)

Home equity indebedness is all debt other than acquisition debt secured by the residence to the extent it does not exceed the FMV of the residence reduced by any acquisition debt. Interest on such debt is deductible even if the proceeds are used for personal expenditures (subject to the limit). However, the debt must be secured by the qualified residence. Until the residence is converted its deductible on Sched A. The CPA's are correct that the texts all say that the the interest paid is then nondeductible personal interest. (For a personal residence)

However, once the property is "converted" to residential rental property the loan is then a business loan collateralized by the rental property. It is therefore deductible on Schedule E as an ordinary and necessary business expense. The personal residence code sections no longer apply to the situation upon convesion. I hope this answers your question.

So are you saying in your last paragraph that the home equity loan interest expense, once the residential property is converted to a rental property, is deductible on Sch E?

I would have thought that the tracing rules apply here and I would consider that personal interest and non deductible on the sch E. I still consider it non deductible...trying to understand the rational here.

To me, the equity loan on the personal residence converted to a rental is the same as pulling out $10k on an equity line on a rental for personal purposes and deducting that interest on the Sch E. I would not take that deduction.

For example: Many of my clients have residential real estate and do all of the billings and repairs, thus materially participate. We refinance existing building to make acquisitions of other properties. We refinance buildings to buy other businesses. Interest of debt incurred in connection with the taxpayers trade of business in which you materially participate is " generally " deductible in full. One of the exceptions to generally is personal interest.

I do not consider this personal because it is collateralized by a business asset as the code states. Persoanl interest under section 163 (h) excludes interest on debt incurred or carried in connection with the taxpayers trade or business.

I understand your logic and that you may not consider that debt incurred or carried in connection with the trade or business since they used the proceeds to buy a personal residence. I don't see it that way since the code or the regs. do not prevent it. If the business took the debt its theirs. If the law does'nt specifically exclude it then its allowed. I advise my clients to take this deduction even if the proceeds are used for personal expenditures. All businesses have the legal right to make a business decision to incurr more debt.

Play golf most of the time. Do may be 100 or so returns during the season. What is your take in the areas of 163 I cited?

I don't agree or misunderstand JCT's 2nd post as follows

"However, once the property is "converted" to residential rental property the loan is then a business loan collateralized by the rental property. It is therefore deductible on Schedule E as an ordinary and necessary business expense. The personal residence code sections no longer apply to the situation upon convesion. I hope this answers your question."

This is what I READ/HEAR is being said:

Let's say my primary residence has a mort of $100k, but is worth $600k. While still living in my primary residence I take out a LOC of $300k to buy an old painting. 3 months later I move out of my home to an apartment for the next 3 years. I convert my former residence to a rental house and lease it for the next 3 years.

Is the interest on the LOC of $300k deductible on Sch E?

I say no and JCT seems to be saying yes...maybe I just don't get it.

Ok, I understand 163(h)(2)(A) as deductible interest properly allocable to a trade or business and 163(h)(3)(A)(ii) home equity indebtedness with respect to a qualified residence.

If the "qualified residence" converts to a rental property then based on 163(h)(3)(A)(ii) that interest is no longer considered qualified residence interest and no longer deductible on Sch A as home equity indebtedness.

So, in my view, now, the LOC interest now has to fall under some other provision of 163(h)(2) in order to be deductible.

If you can trace the LOC proceeds to fall under 163(h)(2)(A) - (F) then you may have a deductible expense. Otherwise, the LOC interest is nondeductible personal interest.

In Ken's original post, it is my opinion that the LOC interest can't be traced to any provision under 163(h)(2) once the qualified residence turns to rental property and therefore is not deductible on schedule E.

I think you summarized it quite well.

Part I: By using "Sched A" for the months the home is "not rented" you have elected to treat the mrtg int exp as residence (Second Home). This portion of the year is covered under Sec. 163 (H)(2)(d) and further defined under (H)(3)(A). Part II. By using Sched E for the months when the home is rented you have elected to convert to residential real estate (ie: trade or business) and qualify under Sec. 163 (h) (2)(A). This is not an "or" statute where you must use one or the other for the entire year. You use them both for the portion of the year as required by the facts. The property was convert from a personal residence to residential rental real eastate at some point during the year and therefore must be represented as such on the tax return.

I don't agree with part II. When the primary residence is converted to a rental house, the original acquisition indebtedness is deductible on Sch E, assuming no passive activity limitations Sec. 163(h)(2)(C). I wouldn't use Sec. 163(h)(2)(A).

However, in my opinion, the interest on the LOC (home equity indebtedness on the former qualified residence) now can't be traced to the qualified residence and therefore can't be deducted on Sch A., nor can any of the proceeds be traced to any of the exceptions under 163(h)(2), therefore in my opinion the LOC interest is personal interest and nondeductible.

I just don't see how the interest expense on debt proceeds on a home equity indebtedness loan can fit into 163(h)(2)(A) UNLESS (1) the debt can be traced to a valid trade or business on a schedule C (in the original post it can't be traced to a trade or business) OR (2) a rental real estate activity under 163(h)(2)(C) (in the original post it can't be traced to another rental property).

"The time the interest accrued" refers to qualified residence and the debt coexist during the same tax period.

Mtm

Rental property does fit under trade of business. Reg. 1.163-8T(n)(3)(iii) Business or rental activity. (A) A business or rental activity is any trade or business or rental activity of the taxpayer. For this purpose- A trade or business includes a business or profession the income and deduction of which are properly reported on Sched C, E, F of Form 1040; and (B) A rental activity includes an activy of renting property blah blah which are properly reported on Sched E. No Sched C is required.

Mtm What is the authority for "tracing"? I'm not familiar with the concept your applying. It seems your saying it must be rental property to rental property debt. It does'nt have to be rental to rental. It just has to be deductible debt secured by the property.

The authority for the tracing requirement is found in Reg. 1.163-8T.

We all come here to read, learn and assist others down the correct road based on our experience. Hopefully, all who have been following this post will correctly apply the applicable rules here and not be taking interst deductions that are clearly non deductible.

Client had personal residence which he refied & used $120,000 from refi to put downpayment on new residence & converted old residence into rental property. It is my understanding that he CANNOT reallocate the interest on the $120k to the new residence as it is not secured by the new residence. The 2006 part of this thread confused the heck out of me, but the 2008 part has been in conformance with what I have always thought.