Mortgage Interest Tracing

By Jason Watson, CPA
Posted Tuesday, August 27, 2024

Generally, interest expense can fall into any of the following categories-

• Investment interest is interest on debt incurred for the purchase of property-held investments, such as stocks and mutual funds, for which the yearly deduction is limited to net investment income. If the investment generates tax-exempt income, the interest is not deductible.

• Residence interest is interest on a home mortgage and is generally deductible as an itemized deduction on Schedule A subject to loan limitations. Qualified home is the IRS terminology, and it includes your main home and second home if necessary.

• Passive activity interest is interest on debt incurred for business or income-producing activities in which you don’t materially participate. This is usually deductible only if income from passive activities exceeds expenses from those activities. Your rental property might fall under this category depending on your participation.

• Trade or business interest is interest on debt incurred for activities in which you do materially participate and can generally be deducted in full. Your rental property might also fall under this category.

• Personal interest, such as personal credit card debit or personal automobiles, is not deductible.

Can you borrow against the equity in your primary residence to purchase a rental property? Absolutely, and it is a common strategy. Can you sidestep loan limitations and deduct the mortgage interest? Yes. It is called interest tracing, and the concept is quite simple. The use of the loan proceeds determines its deduction eligibility regardless of the actual real estate property or other asset securing the loan.

Treasury Regulations 1.163-8T(c) reads in part-

The last sentence is the important one and it reads in part, “debt proceeds and related interest expense are allocated solely by reference to the use of such proceeds.” As you might be aware, the Tax Cuts and Jobs Act of 2017 added limitations to how much home mortgage interest may be deducted. Specifically, for loans after December 15, 2017, the limit is $750,000. This means if you have $50,000 in mortgage interest on a $1,000,000 loan, only the first 75% or $37,500 would be eligible for deduction on Schedule A of your Form 1040 tax return.

How does this play into the interest tracing rules? Treasury Regulations 1.163-8T(m) reads-

What does this gibberish mean? Loan interest is chopped up (fancy accounting term would be allocated) depending on the ultimate use of the loan proceeds without regard to limitations. However, once allocated to various categories (as we listed above), then various interest limitations come into play which are mostly detailed in IRC Section 163 such as the $750,000 limit above.

Now what? Here are some examples. Let’s say you own a primary residence with $500,000 in mortgage loan debt. You borrow another $600,000 for home improvements and to buy a rental property. Of the $600,000, $200,000 is used for home improvement with the remaining $400,000 being used for the rental property purchase. Freshen up that kitchen and master bath plus build some wealth. Nice!

The interest on the $200,000 is fully deductible on Schedule A on your individual tax return alongside the first loan interest (since both balances combined are $750,000 or less). The interest on the $400,000 portion is fully deductible on Schedule E of the new rental property.

We’ll reverse it a bit. Let’s say you borrow $1,000,000 against your rental property to buy a primary residence and to also buy another rental property. Why not, right? $800,000 was used to buy the primary residence and $200,000 was used to acquire the second rental.

You would deduct 75% of the interest ($750,000 divided by $1,000,000) on Schedule A. 20% or $200,000 would be deductible on Schedule E for your new rental property, and $50,000 ($800,000 less $750,000) or 5% would be excess interest associated with the primary residence and therefore not deductible.

Here are some pitfalls-

• There are ordering rules should you mix borrowed funds with un-borrowed funds. As such, keep monies separated to assist in the tracing part of the interest tracing provisions.

• The qualified home limitation of $750,000 referenced above encompasses your main and second home. Depending on your objectives and tax footprint, if your second home slips into being a rental property you might be limited on your mortgage interest deduction. See our vacation home rules section.

Keep in mind that the cost of your equity is usually more expensive than the cost of borrowing. Not always, but usually. We can get into the tax-effected rate of return on your equity versus the property appreciation-effected cost of borrowing, internal rates of return, and all the hoopla, but generally using other people’s money to fund your real estate investment empire is preferred. There are several books and internet content dedicated to the real estate leverage topic.

Please see our capitalizing construction mortgage interest section which discusses the capitalization of mortgage interest during construction or renovations.