Rental Property Cash Out: How’s It Taxed?
If you cash buyout an under-priced residential rental property and finance it for more than your basis (buyout plus a little fixup), and then use that extra money on a personal expense, can you deduct the entire mortgage interest on schedule E for the property? The tenants continue to occupy the rental.
Thanks,
I am not a CPA and only a CPA can tell you for sure, but I'm pretty sure that those expenses you paid for with that money have to be "business related" if you want them to be tax deductible...
Anybody else on this?
Good Luck!
[addsig]
I went to two different CPA’s and I got opposite answers. When I asked them to back it up with the tax code, the one who argued for deducting on schedule E said: “chance of audit are very slim”. And the other one who looked into the various possibilities said it had to be “traceable to investment, business, etc”. The interest expense would be reported on schedule C. I don’t have a business, so it won’t help me; I can’t deduct the interest from nothing.
So is it just a question of how much risk you want to take with an audit?
Go to a new CPA. You can deduct the interest expense and repairs (not capital improvements that has to be amortized) from the income you make off the property, you don't have to be incorporated.
Now the part of the interest from the cash out is very suspect. Why don't you take the cash out from your HELOC instead of the rental property?
Go to a third CPA? I guess it wouldn’t hurt. Except the $100 or so for their time if they don’t answer the question quickly. I didn’t take a HELOC because the my house is a “distressed property” meaning that I don’t live in anything that is rentable.
I rent everything that I can possibly rent. I wanted the money to spend on my “house” to fix it up, so I could rent it. I wonder if I did fix and rent my home, could I just deduct the interest on its schedule E? Even though the loan is on another rental property?
Plus I was greedy, I didn’t look before I leaped and forgot to check on how I was going to deduct the interest until after I got the loan
I believe you should be able to deduct the loan interest on the Scedule E of the property that you are fixing up.
The reason I thought of another CPA was that in my humble opinion, one of the CPAs didn't seem too bright, and the other was a bit too shady for me.
You can deduct any and all interest on a loan that is secured by the rental property, regardless of how you use the proceeds (you can buy a Corvette, vacation, etc).
You can only deduct repairs expenses if you used the money for repairs on the rental. And, you can only adjust your basis and take additional associated depreciation if you used the money on capiatal improvements on the rental.
jspaeth is exactly right. The interest on a mortgage secured by business real estate is deductable regardless of whether the proceeds of the loan were used for business purposes or not. Likewise the "cash" out of the refinance is not income.
If, however, you subsequently sell the property for an amount equal to your loan but higher than your basis you will have a taxable event with no actual money to your pocket to pay the taxes with.
Sorry, interest is deductible based on what the proceeds were used for and have nothing to do with what secures the loan (unlike your primary residence). IRC Reg Sec 1.163-8T - "Debt is allocated to expenditures in accordance with the use of the debt proceeds and, except as provided in paragraph (m) of this section, interest expense accruing on a debt during any period is allocated to expenditures in the same manner as the debt is allocated from time to time during such period. Except as provided in paragraph (m) of this section, debt proceeds and related interest expense are allocated solely by reference to the use of such proceeds, and the allocation is not affected by the use of an interest in any property to secure the repayment of such debt or interest." This is especially true if you're subject to passive loss rules. However, if you have a 1098 for the Sch E property, it's probably not too likely they'll ask questions, but you never know. I would be skeptical of a CPA that only says "chances are slim that they will catch it" Now the CPA that gives you his best interpretation and your other options is worth the money.
blueford said it well and is correct. I recently answered a similar question in this Tax Forum under a post entitled "LLC Cash Out / Taxes?". I went into some other related detail about what is taxable and what is not and how to categorize and think about the various cash flows.