Pros Answer: “How Can I Get Schedule E Mortgage Interest Deduction On Refi?”

Since my previous Topics: “How Can I Get Schedule E Mortgage Interest Deduction On Refi?” and “Rental Property Cash Out: How’s It Taxed?”
were getting long and drawn out, and since I now have answers from 2 CPA’s, the IRS, and an experienced 1031 professional, I thought I would break out the answers in a new Topic.
For those that want to, read the old Topics to see what was discussed.


I talked to another CPA, he told me that the mortgage INTEREST had to be allocated as to how the money was spent. The money can be spent on anything, but if you want to deduct the INTEREST it has to be spent on business, investment, etc. and traceable.

The second CPA backed up basically the same thing with his tax research service. His question to the research service:

Circumstances: A taxpayer has a residential rental property, the activity which is reported on his Schedule E. This property has been owned for a many years and no longer has a mortgage. The taxpayer than takes out a mortgage on the rental property. The collateral on the mortgage is the rental property. The proceeds of the mortgage are spent on buying raw land as an investment.
The land will not be rented out and no buildings will be constructed. Question: Is the interest paid on the mortgage deductible on the Schedule E of the involved rental property or is it investment interest reportable on Schedule A.

Answer: The interest will be traced to the debt proceeds. In this case, the interest would be deducted as investment interest on Schedule A. More information can be found on this topic in IRS pub. 535, Chapter 5.



I also went to a seminar on 1031 exchanges last night and the speaker (not a CPA, but experienced in real estate taxation) also said that the mortgage money has to be reinvested for the INTEREST to be deducted.

Oh, and look, an answer from the IRS just showed up:
My question to the IRS was:
I purchased a residential rental property 15 years ago, using to a $17,000 mortgage. I paid off the $17,000 mortgage on the rental property.
Can I deduct all the mortgage interest from a new $40,000 mortgage on the residential rental property using Schedule E, no matter what the proceeds are spent on?


The Answer To Your Question Is:
Thank you for using our service. I apologize for the delay in responding. If the proceeds of the loan are not spent on the rental property, then you cannot deduct the interest as a rental expense. The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, investment, or passive activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan’s proceeds. Allocate your interest expense to the following categories.
Trade or business interest
Passive activity interest
Investment interest
Portfolio interest
Personal interest.
In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.
Example. You secure a loan with property used in your business. You use the loan proceeds to buy an automobile for personal use. You must allocate interest expense on the loan to personal use (purchase of the automobile) even though the loan is secured by business property.

"Proceeds not disbursed to borrower" Even if the lender disburses the loan proceeds to a third party, the allocation of the loan is still based on your use of the funds. This applies whether you pay for property, services, or anything else by incurring a loan, or you take property subject to a debt.
"Proceeds deposited in borrower’s account" Treat loan proceeds deposited in an account as property held for investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest expense. If you withdraw the proceeds of the loan, you must reallocate the loan based on the use of the funds. For additional information see the Publication 535, Business Expenses. I hope this information is helpful.

So the final answer: To get the maximum interest deduction on that rental property’s Schedule E, you have to spend all the mortgage money on that rental property.
If I invest it, it goes on Schedule A. If I have no offsetting business gains, then I lose the interest deduction.
If I invest it all in another rental property, I deduct it from that rental property’s Schedule E.
More than likely I will have to allocate it to different things and deduct it or not in various ways.

I think that most people just take the interest deduction on their Schedule E and hope they don’t get audited. From all my discussions and research it seems obvious the IRS is very restrictive on allowing deductions of INTEREST. Even the Home Mortgage Interest deduction is pretty restrictive.
bizboy