Pay Cash, Lose Your Tax Deduction?

[Emilio Ramirez]

I recently read somewhere, I think in Edelman's book, that if I bought a property for cash and then took out a home equity or some kind of note that the interest is not deductable versus if I purchased the property straight away with a down payment and a mortgage. Is that true?

What about a second? Is the interest deductable there?

Thanks

[Dave Toelkes]

Could be true. Depends upon the amount borrowed on the home equity loan, how it was borrowed, and what you did with the money.

Of course, we are only addressing the mortgage interest.

Buyers that finance their purchase with a mortgage loan secured by the investment property they are buying can take a mortgage interest deduction on Schedule A if they itemize, or on Schedule E if the property is used as a rental.

When a home equity loan is used, the interest is deductible in some cases but not in others.

Let's create a couple of scenarios.

First, let's use an equity loan on an investment property you own free and clear. Let's say you use all of the loan proceeds to either improve the investment property that secures the loan, or to acquire more investment property (perhaps a rental). In this case, the mortgage interest is deductible depending upon how you use money.

If you used all of the money to improve the investment property, then the mortgage interest is a Schedule A investment interest deduction (not a home mortgage interest deduction)..

If you used all the money to purchase a rental property, then the mortgage interest is a rental property expense on Schedule E for rental property.

If you used the money to go on a vacation, buy a new car, or pay off credit cards, or a personal loan, then none of the mortgage interest is deductible.

In the second scenario, let's use a home equity loan on your primary residence (or your second home).

If you use all of the loan proceeds to improve your primary residence (or second home) then the mortgage interest is a home mortgage interest deduction on Schedule A..

If you use all of the loan proceeds to purchase investment property, the mortgage interest is deducted on Schedule A as investment interest. However, if you use all of the loan proceeds to purchase a rental property, then the mortgage interest is deducted as a rental expense on the Schedule E for that rental.

If you don't use the loan proceeds for a qualified investment or to improve your primary residence, you can still take a home mortgage interest deduction on Schedule A for the interest paid on the first $100K of your primary residence home equity loan. Does not matter what you did with the money.

The home mortage interest deduction on Schedule A is limited to the interest paid on the first $1 million of purchase money mortgages plus the interest paid on $100K of home equity debt. If your total indebtedness exceeds $1.1 million, then any interest paid on loan amounts above $1.1 million is not deductible as a home mortage interest deduction.