Tax implications of carrying debt on primary vs investment property?

Question

Hi there,

My husband and I are first-time landlords due to a property inheritance.  The home we inherited does not currently have a mortgage on it.

We are looking at refinancing our primary residence, and I'm thinking there will be a tax benefit to shifting some of our debt to the rental property, but I was hoping someone on this forum can validate or disprove my thinking.

Every year we end up paying the Alternative Minimum Tax, which makes a portion of the mortgage interest on our primary residence non-deductible.  I'm thinking that we should shift part of the loan balance on our primary residence to a mortgage on our rental property, so that the interest can be expensed against the rental income, and not hit AMT limits.

Does anyone see any holes in this logic?

Thanks much!

Kelle

David Collins · Answer

Good advice here already. In addition, though, keep in mind the so-called interest "tracing" and "allocation" rules. These tax rules provide that the categorization of interest expense depends on how the proceeds of the debt is used.

Thus, it's not the fact that a loan is secured by rental property that makes the interest "rental" expense, it's the fact that the loan was used to acquire the rental property. If you borrow against a rental property and use the proceeds for, say, a vacation and a new boat, the interest on the loan will not be deducted on Sch E as a rental expense. (It'll most likely be nondeductible personal interest.)

On the other side of the coin, if you get a cash advance against a credit card and use that cash to make a down payment on a rental property, then an allocable portion of your credit card interest will be "rental" interest on Sch E.

Check out IRS Publication 535 for more info.

Jon Holdman · Answer

If you're paying AMT you must be using a CPA for your taxes.  If not, you really should, as a good one can save your far more than they will costs.  This is a question for your CPA.

Yes, interest on debt on rental properties is deductible.  However, then net taxable income on the rental property, which may well be negative with the expenses, interest, and depreciation, is probably not usable to offset ordinary income.  This is a "passive loss", and those cannot be used to offset ordinary income, except under to specific exceptions.  One is that your AGI is under $150K.  If you're paying AMT, I assume its not.  Even then this "special allowance" is limited to $25K if your AGI is under $100K, and phased out between $100K and $150K.  The other exception is if your a "real estate professional". That means you spend at least 750 hours a year doing real estate related activities AND that you spend more hours on real estate than anything else.  So, if you have a full time W2 job, 2080 hours a year, you must spend 2081 hours a year on real estate.

The deductions, including interest, on rental properties can shelter the rental income. They're not that useful, however, in sheltering other, ordinary income.

Tom NA · Answer

Hi Kelle,

I think you're right on with your logic.  As someone who is in a very similar situation as you, that is one of the main reasons that I don't use cheap debt on my principal residence to pay down my higher cost rental property mortgages.  In the end, it really does depend upon your tax situation which one makes more sense and I believe your thinking is spot on.

The one thing that you should do, however, is to estimate how much income you will have after all other expenses, including depreciation on your new rental property.  Loading up any more debt on the property than what makes you break even for tax purposes probably wouldn't make much sense (unless you have an alternate use for the excess debt you would be putting on the property).

Of course I'm not an accountant nor do I play one on tv so all of the standard disclaimers apply.