The intricacies of home mortgage regulations can often lead to confusion and misutilization. One specific area that causes confusion is interest tracing rules, which permit taxpayers to deduct mortgage interest based on the utilization of the borrowed funds (Treas. Regs. §1.163-8T(a)(3)). For instance, if a taxpayer secures a mortgage loan with their home and uses the funds to buy a rental property, the interest tracing rules allow the taxpayer to trace the use of the funds and deduct the interest on Schedule E.

When it comes to allocating interest between multiple uses, taxpayers can employ any reasonable calculation method, provided they consistently use the same method each year. However, in this case, how do you maximize mortgage interest deductibility?

Let’s discuss interest tracing rules, home mortgage rules, 10T elections, and how to properly utilize home equity loans for more than one financial purpose.

Understanding Interest Tracing Rules

Interest tracing rules are essential tax regulations that determine how interest expenses can be deducted based on the use of borrowed funds. These rules allow taxpayers to allocate interest expenses to various income-producing activities, such as business investments (i.e., purchasing a rental property) and paying off personal debt.

As specified in Treasury Regulations §1.163-8T, interest tracing rules state that the deductibility of interest is determined by the use of the loan proceeds rather than the collateral securing the loan. This means that if you take out a loan and use the funds for different purposes, you must allocate the interest expense accordingly.

Home Mortgage Rules: Personal Residences

Typically, the allocation of interest on a loan is based on the use of the loan proceeds. However, there’s an exception for personal residences. The character of interest on a personal residence is determined by how the debt is secured. If the debt is secured by a personal residence, the interest is deductible as home mortgage interest on Schedule A, but only if it is acquisition debt and within the mortgage interest limitation, which is currently $750,000 for debt incurred after December 15, 2017 (IRC §163(h)(3)).

When the total debt secured by the home is equal to or less than the $750,000 home mortgage debt limitation, the interest cannot be traced away from Schedule A without a 10T election.

The 10T Election Explained

A taxpayer has the option to treat any debt secured by a qualified home as if it were not secured by the home, known as the “10T election” (Temp. Treas. Regs. §1.163-10T(e)(4)). When this election is made, the entire debt is considered unsecured by the residence, allowing the debt proceeds to be traced to their use without the mortgage interest limitation shown.

The 10T election must be applied to the entire amount of the debt, not just a portion. This treatment starts with the tax year for which the election is made and continues for all subsequent tax years. The election can only be revoked with IRS consent and is made on a loan-by-loan basis.

Example of Interest Tracing (under $750,000)

Mike, who owns his home outright, secures a $500,000 loan against his property. He allocates $300,000 (60%) of this loan to home improvements and the remaining $200,000 (40%) as a down payment on a rental property.

Since $300,000 (60%) of the loan proceeds were used to improve his home, this portion is considered acquisition debt. The remaining $200,000 (40% is classified as equity debt.

Mike can deduct 60% of his loan interest on Schedule A. However, he cannot deduct the remaining 40% on Schedule A because it is classified as equity debt. Additionally, he cannot trace this interest to Schedule E unless she makes a 10T election.

However, if the total debt secured by the home exceeds the $750,000 mortgage interest debt limitation, taxpayers can trace the portion of the loan proceeds exceeding this limit away from Schedule A without needing a 10T election (CCA 201201017; Treas. Regs. §1.163-10T(e)(4)).

Example of Interest Tracing (over $750,000)

Jane purchased her home with a $500,000 mortgage, all of which is classified as acquisition debt. She later secured a $400,000 loan against her property.

Jane allocated 40% of the new loan ($160,000) to home improvements and 60% ($240,000) to purchasing a rental property.

Without making a 10T election, Jane can deduct the following interest on Schedule A:

• First loan (acquisition debt): $500,000
• 40% of the second loan (home improvements, acquisition debt): $160,000
• Total acquisition debt deductible on Schedule A: $660,000

For the remaining portion of her second loan, Jane can trace the interest to her Schedule E rental property, but only for the amount exceeding the $750,000 mortgage interest limitation:

• Mortgage interest limitation: $750,000
• Acquisition debt deductible on Schedule A: ($660,000)
• Loan proceeds not deductible on Schedule A or traceable to Schedule E: $90,000

Therefore, only $150,000 of the new loan proceeds can be traced to Schedule E, and only the interest on this portion is deductible on Schedule E:

• Loan proceeds used for rental property: $240,000
• Loan proceeds not deductible on Schedule A or traceable to Schedule E: ($90,000)
• Loan proceeds traceable to Schedule E: $150,000

Pro Tip: Secure Separate Home Equity Loans for Each Financial Purpose

If you want to use the equity of your primary residence to simultaneously invest in a business, such as a rental property, and invest in your home or pay off personal debt, you should secure separate loans for each purpose.

Secure a loan for home improvement, secure a loan for personal debt payoff, and secure a loan for rental property investment. This technique will allow you to maximize the deductibility of your loan interest. Otherwise, you may limit your ability to deduct interest on your tax return. 

In the example above, Jane could have maximized her interest deduction by taking out two additional loans instead of one:

• One loan for the $160,000 of home improvements
• One loan for the $240,000 rental property acquisition

By doing so, she could have deducted all of the interest on the $160,000 loan as acquisition debt on Schedule A, and then she could have made a 10T election for the second loan, allowing her to trace the entire additional loan to Schedule E.

Sources:
https://www.irs.gov/taxtopics/tc505