Second mortgage on residential real property?

Question

15 years ago, I bought a residential property and lived in it for two years. Then I moved away and rented the residential property. I have paid down the original mortgage quite a bit. Can I take a second mortgage now to harvest some equity and put more interest expense on the annual rental property tax calculation?

If that is possible, I would appreciate a reference or references to information, rules, etc. that are related to that transaction.

Thanks.

If that is possible, I would appreciate a reference or references to information, rules, etc. that are related to that transaction.

Thanks.

David Sicks · Answer

@ Raj,

You wrote:

"If this were not the case people could pull out equity and purchase vehicles, take family trips, go on shopping sprees, etc and still be able to deduct for these lifestyle changes. At least that's how I see it (though I could be wrong). I know there are folks who probably do these things fairly often, but I personally prefer to play it safe should any questions be raised."

I am just turning over possibilities.  I don't know much about real estate, but I do know that people are able to take reverse mortgages, if not for sake of "lifestyle changes", for lifestyle maintenance.

I find the tax code  (on rental real property depreciation, for example) complicated to the point of being absurd.  I struggled for hours to find someone at the IRS who would interpret it so I could do my Schedule E with Turbotax.  Thus, I now take nothing for granted.  Probably I have at least three choices: (1) to get some kind of reverse mortgage or refi on the rental property; (2) to do that with my residence; and (3) to pay cash to remodel my wife's kitchen.  I am sentimentally disinclined to pay cash because so many remodel jobs cost more than they are worth, value-wise.

Anyway, first things first, namely, what are the tax implications of taking a new loan on the residence or the residential rental property?  What is prohibited and what is allowed?  Probably the right question is where do I look to sort that out.  Because the tax code is so convoluted and arcane, I hope to get some pointers.

Raj T. · Answer

@Bill/Jon,  thanks for the insight here.  Another way I like to think of things is getting 28 cents (or so) for every dollar you spend on interest (or some other deductible expenditure).  If given the choice, why bother spending the dollar in the first place?

@David,
  If I understand your question/intent correctly, the IRS does not view favorably on people pulling out their rental property equity (and deducting interest expenses) unless the funds were to be applied towards the repair/improvement/maintenance of that very same rental property.  Maybe this was just for HELOCs, I forget the few places I'd seen it and where it made sense.  It may be mentioned in the tax form instructions too - where the loan interest which is being made deductible has to be used for a refi or in some way towards activity related to the property.  
If this were not the case people could pull out equity and purchase vehicles, take family trips, go on shopping sprees, etc and still be able to deduct for these lifestyle changes.  At least that's how I see it (though I could be wrong).  I know there are folks who probably do these things fairly often, but I personally prefer to play it safe should any questions be raised.  Just my .02.

David Sicks · Answer

@ Bill and Jon

I would like to do some remodeling on my residence (not my rental property), so I need cash to do that.  When I pay off my now rental property mortgage, that property will begin to show more taxable "profit".  I do not think I would gain any advantage at all to get a home improvement loan on my residence, but I might be wrong.  I think if I did, and changed from taking the standard deduction to itemizing including interest on the new home loan that my combined rental / residence tax situation would be not be much improved.  Hence, the idea of getting a new mortgage on the rental property where mortgage interest could be an expense to offset rental income.

I am looking for ideas and advice at this point.  Not my bailiwick, but I am not as green as I look a cabbage.

Jon Holdman · Answer

Because its a rental, it will probably be easier to do a cash out refi than to get any sort of LOC.  I have seen some recent posts that lenders are starting to do LOCs on investment properties, but that's still unusual.

This is a REALLY BAD reason to do a refi.  Getting the cash and using it for some worthwhile purpose is a good reason.  But increasing your interest deduction is incredibly bad.  If you pay out a dollar in interest and can deduct that, you're spending $1 in pre-tax money.  If you don't spend that dollar, you have to pay tax on it and then you have whatever is left after paying tax to put in your pocket.  Paying interest costs you money.  Not as much as if you paid the interest after tax, but it still takes money out of your pocket.  Don't fall in the trap of thinking you will come out ahead by paying more interest because its tax deductible.  You do not.

Bill Gulley · Answer

Welcome to BP David.

Yes, you can get a second if you can find a lender willing, you can deduct the interest depending on your basis, but not amounts in excess, see your tax advisor or, here, see ours.... Steven Hamilton II, @Bill W.