I'm considering buying an investment property with cash (such as foreclosures that are only available to cash buyers). I have the cash for it, but I would like to later get a mortgage on it so I don't have so much cash tied up in it. But if I do that, would the mortgage interest be deductible from my rental income?
Here's another twist. The cash I have right now came from doing a cash-out refi of another completely paid off rental property I have. If I take that cash and buy a property with it, is the interest on that cash-out refi deductible from my rental income for either property? So far these are all just in my own name, not with an LLC by the way.
@Jim P. ,
Yes, they are deductible against rental income.
The refi interest offsets the rental income of refi property
Same way, when you refi new cash-bought property, it’s a repeat.
They don’t have to be in LLc
The risk factor is purchasing a foreclosure property that may have severe damage and take a lot of rehab dollars to make lendable. I recommend using LLC's in all investment strategies and finding a licensed CPA specializing in real estate investment. My thoughts are tying up the cash in just one property may not make sense. Also, if you are looking to fix and flip that poses a whole new set of tax guidelines to consider.
In the scenario you describe, it would be deductible under the interest tracing rules. Consult with your CPA as to how this works.
Yeah, I'm going to look for a CPA soon, but it's probably hard to talk to one this time of year I'm guessing. I'll probably wait until later in the month to try to contact one.
The interest would be deductible.
Furthermore - You are not required to have the loan in an entity for it to be deductible.
@Jim P. - I hate to be the party pooper, but someone has to.
Before I go there, let's address the practical aspect. If you end up with 2 loans against 2 rental properties, each reporting annual interest on a respective Form 1098 linked to that property - 99% of all investors and 98% of all CPAs will deduct it. The IRS will never challenge this deduction, because 1098s match - and that's the end of the IRS curiosity.
However, whether or not you can legally take these deductions is a different issue altogether. In the tax law, interest is deducted based on what the loan is used for, as opposed to where the money came from. (There was one notable exception, a $100k of HELOC interest, but it has been killed by the tax reform.)
You can deduct interest if the loan is used for one of these purposes:
- Buying or improving your personal residence
- Buying income producing investments, like stocks or notes
- Funding business operation
- Buying business assets, including investment RE
Now let's play with your example.
- Property A was free and clear
- You secure a $100k Loan A with this property
- You use $80k of that money to buy and rehab Property B
- You eventually refi Property B with a $90k Loan B.
Step 2. Just because you obtained a loan against your investment property does not create a tax deduction for the interest. Not yet. (And no, there is no "acquisition debt" loophole, since the property was free and clear)
Step 3. $80k is used for business purposes. So, interest on the $80k is deductible, but not on the remaining $20k. In other words, 80% of the Loan A interest is deductible. And it is deductible against Property B, not against Property A!
Step 4. Now, Property B is funded with Loan B. All good, but only $80k of Loan B is connected to the business, as it replaces the acquisition debt. The remaining $10k is not deductible. So, a portion of the Loan B interest is deductible against Property B. The ratio is 8/9 ($80k of $90k).
What happened to Loan A? It is no longer deductible! Unless the freed-up Loan A cash is applied towards the next acquisition.
Do you see it can get hairy? Spare the messenger, please.
PS. LLCs, as already mentioned, do not change this scenario.
@Michael Plaks thanks for that excellent explanation. Yeah, I think that all makes a lot of sense.
So let's see if I'm doing this correctly. Let's say I have a paid-off investment property and I did a cash-out refi to take out $100k last year. I used that money for investing in stocks and things so last year I put the interest from that refi on my Schedule A Itemized Deductions line 14 "investment interest".
If this year I sell the stocks and use that same $100k to buy an $80k house. So then 80% of that refi interest is now deductible on that house's Schedule E as mortgage interest. (And if I use the other $20k left to invest in stocks again, that 20% of the refi interest can also be deducted on my Schedule A line 14.)
Is that right?
Here's something I don't know the answer to... if I buy a foreclosure house with cash and immediately get a mortgage for it so I can get my cash back, I guess that would basically be a cash-out refinance. Would that mortgage interest be deductible on that house's Schedule E as mortgage interest? I think I saw something about it being considered interest for the property if you do the financing within 90 days after the sale or something like that.
Correct to everything above "Is that right?"
As to the almost immediate refi (90-days or whatever) - honestly, I do not know. It is possible that there was some court case treating it as acquisition debt, but I have not heard of it. Maybe one of my colleagues will chime in and plug the hole.
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