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How does loan source impact where/how interest is deducted?

Your question:

I have a borrower who has a HELOC on their primary residence that they used to pay off their mortgage on their rental. On their schedule E, they have written off the interest on the rental (even though the subject property on the loan is their primary residence). Is this allowed? On line 40 of their 1040, they took the standard deduction of $11,400.

Linda says:

You have stumbled on an area where there are different points of view. On the one hand, IRS Publication 535 on Business Expenses says:

Secured loan. The allocation of loan proceeds and the related interest is not generally affected by the use of property that secures the loan.

Most preparers look to the use of the loan, not the source of the loan, when considering whether or where to deduct the interest expense. There are some exceptions for loans secured by your primary residence.

Odd-Ball Example

To give you an example of an odd-ball situation, my personal residence is on two acres and we have two rental properties on it. There is not a separate mortgage for the rentals…it is all in one. I allocate the interest on my personal residence between Schedule A and the two rentals.

How to treat it…

I would not worry about what is securing the loan that they are using for the rental. In this case, depending on how you treat debt, you can treat the HELOC as rental payments or as personal residence payments. I’d be inclined to treat it as rental debt.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.