Deducting interest on a rental refinancing.

Early on in the disallowance of personal interest deductions, it became clear that borrowing against the equity of a rental property for personal use would be a costly proposition. In Letter Ruling 8803018, for example, the IRS ruled that the interest on a rental-equity loan used to finance the construction of a new residence would be personal interest. In line with the temporary regulations under Sec. 163, the combination of the loan not being secured by the taxpayer's residence and the loan proceeds not being used for investment or business purposes placed the loan interest outside the realm of deductibility. Consider, though, the following scenario.

Example: Taxpayer X has several
rental properties with combined
annual income and expenses as follows:
  Rental income        $50,000
  Rental expenses      (25,000)
  Depreciation          (5,000)
  Net rental income    $20,000

X is planning to borrow $100,000 against one of his rentals for the purpose of supplementing his current income, traveling and helping his children. If the interest, which will run about $7,000 a year, is deductible, given a combined Federal and state tax bracket of 35%, his annual interest cost would be reduced to $4,550 ($7,000 x 0.65), an annual savings of $2,450.

Under guidance that is currently available, it appears that by carefully structuring the transaction, a taxpayer can receive a full deduction for the interest while using the positive cash flow from the rentals to finance personal expenditures.

Sec. 163(h)(2)(c) provides that interest allocable to a passive activity is not personal interest, but instead is taken into account under Sec. 469. Temp. Regs. Sec. 1.163-8T(c) requires that interest on a loan is allocated based on how the loan proceeds are used. Furthermore, Temp. Regs. Sec. 1.163-8T(c)(4) illustrates that loan proceeds deposited in a separate bank account characterize the related loan interest as investment interest until the proceeds are used for other purposes.

With these rules in mind, the taxpayer in the example should (1) open a new bank account to be used exclusively for the loan proceeds, (2) deposit the entire loan proceeds into the account and (3) use the money in the new account exclusively for paying all rental expenses.

As illustrated in Temp. Regs. Sec. 1.163-8T(c)(4), the character of the interest will be easy to track; portions of the loan spent on rental expenses will be allocable to passive activities and the amount remaining in the bank account will be allocable to investment. As a result, interest on the loan should be deductible as rental or investment interest and the client will have the benefit of an additional $25,000 of annual cash that otherwise would have to be used to cover rental expenses.

Additional support for this concept is provided by Notice 88-20, dealing with passthrough entities.

In the case of debt proceeds of passthrough entities used to make distributions to the owners of the entity, the debt proceeds and associated interest expense may, at the option of the entity, be allocated among the expenditures (other than distributions) of the entity during the taxable year, to the extent that debt proceeds have not otherwise been allocated to such expenditures.

One caveat to this approach is that the anti-abuse provisions under the allocation rules of Temp. Regs. Sec. 1.163-8T(c) have not yet been issued; it is unknown whether the above scenario would be seen as abusive. However, some solace is taken in suggestions made to the Treasury in the committee reports to the Technical and Miscellaneous Revenue Act of 1988, which was enacted after the temporary regulations under Sec. 163 were issued. In the discussion on how to allocate interest between investment and personal, Congress suggested that simplified allocation rules be adopted which may include reference to the nature of property securing a loan as the determining factor in how it is allocated.

With real estate prices currently down, and with no meaningful capital gains preference yet available, many property owners are understandably reluctant to cash in on their equity until the selling environment improves. This simple strategy may provide property owners with a cost-effective approach to tapping into their equity, while biding their time until better selling conditions arise.