What if you use a loan secured with one property for another rental property or other purpose? For example, you might take out a HELOC or cash-out refinance on your personal residence, and use that money to buy a rental property, or to improve a rental property. In that case, the interest on that loan is deductible as an expense for the rental property because the money is used for the rental property.
The property that is securing the loan might be your residence (or another rental property), but generally the property securing the loan doesn’t matter. What matters is how the money is used. This is called the loan tracing rules (see IRS publication 535, Allocation of Interest subsection).
By the way, if you take out a HELOC or second mortgage on your rental property, and use that money for personal purposes, the interest on that loan wouldn’t be deductible as a rental expense. It would only be a deductible loan if the money is used on the rental property.
Allocation of Interest from One Loan for Multiple Uses
To keep things simple, it’s best if you use all the funds from each loan or line of credit for just one purpose. But sometimes that’s not an option.
If you use the money from a loan for more than one purpose, then you must allocate the percentage of the interest that goes to each purpose. For example, let’s say you withdraw $100,000 from a HELOC on your home, and you use $50,000 (50%) of it as a down payment for a rental property, $40,000 (40%) to renovate your home’s kitchen, and the remaining $10,000 (10%) you spend on a vacation. In that case, 50% of the interest can be deducted on your Schedule E as interest expense for your rental property. Since a portion of the loan was used for home improvement, that 40% of the interest can potentially be entered on your Schedule A as your home mortgage interest (if you itemize). And the remaining 10% of the interest isn’t deductible because it was used for personal use.
The same allocation of interest applies even if you take out money from a line of credit at different times. It’s treated as one loan if all the money comes from one line of credit and it all accrues the same interest rate, until you pay off the line of credit.
If you partially repay the loan or line of credit, then it is treated as being repaid in this specific order:
- Personal use
- Investment/passive activities (except those in #3 below)
- Rental real estate passive activities where have active participation
- Former passive activities
- Trade/business use for certain low-income housing projects (rare)
Transaction Ordering in a Bank Account
If you borrow money and deposit those funds into your bank account that is used for other purposes, it’s generally best to make the expenditures to use those funds within 30 days before or 30 days after the loan funds are deposited in the account. If the funds remain in the account longer than 30 days before they are put to use, the funds may be deemed to have been used for whatever transactions occur after the loan funds deposit. All the specific rules get a little complicated in that situation, but see “order of funds spent” in IRS publication 535 for details.
Loan Costs (Closing Costs)
Costs incurred to do the cash-out refi or HELOC (lender fees, closing costs, points paid, loan costs, etc.) can be amortized over the term of the loan. For example, if you do a cash-out refi with a 30 year term, then 1/30th of the lender fees and other costs for the refinance can be deducted as an amortization expense on your Schedule E each year.
If you had a previous loan with costs that you had been amortizing that is being replaced with the new loan, any remaining amortization of the old loan costs can be deducted in the current tax year as an expense. One exception would be if the new loan is considered to be a continuation of the old loan (just with slightly modified terms), in that case the amortization of the old loan would be added to the amortization of the new loan. But that would be unusual and not typical for a cash-out refi situation.
