Even before the TCJA introduced us to higher standard deductions, it has always been important for tax professionals to determine what borrowing against the primary residence has been used for, whether the loan was a first mortgage or a home equity line of credit (HELOC).
In this post, rather than concentrate on whether or not interest is deductible on Schedule A, I plan to concentrate on what the borrowing was used for. As we go through this, we’re going to assume your client’s principal residence is the collateral for the loan. However, the money was not used to buy, build, or substantially improve the client’s primary residence.
What we’re going to talk about is interest tracing rules. In other words, “Show me the money!” (or at the very least, show me what did you do with the money).
Before we begin, the first thing we are going to have to re-learn is how to establish lines of communication with our clients in order to get the information that we need. Introverts…I’m talking to you! Talk with your clients.
What Are the Interest Tracing Rules?
Basically, interest-tracing rules require the client to show you the money — -what it was used for. The rules tell us that interest is classified based on what was done with the borrowed money. Based on that use, we know where the interest can be deducted…or IF it can be deducted at all.
If your client borrows against their house and doesn’t use the money for a business or investment venture, then we have to assume the use is personal. Borrowing against their house to take that once-in-a-lifetime trip to Fiji is an example. There is NO deduction available for that. The problem is the bank still issues a mortgage interest statement making it look like a tax deductible item. This is where communication is vital.
Taxpayers can borrow against their house to make an investment such as a can’t-miss stock tip or other investment. Once again, the bank issues a 1098 for the mortgage interest. Discussions with the taxpayer will tell you the interest is not deductible on Schedule A — at least not as mortgage interest. An investment interest deduction is limited to investment income on Form 4952, Investment Interest Expense Deduction, and the result ends up on Schedule A unless the investment interest was used for trade or business purposes for example.
Sometimes shareholders in S corps are given the opportunity to buy more stock in their company. What we want to be able to do is deduct the loan interest (let’s assume once again they borrowed against their principal residence with either a first mortgage or a HELOC) for the stock purchase directly against the S corp income on Schedule E. But be careful — — the IRS has special rules to determine the deductibility of interest on loans to purchase S corp stock. There is a requirement to show what the S corp did with the money. If the money was used by the S Corp for business activities, then we can deduct that interest on Schedule E directly against the S corp profit. If the S corp used the money for investment purposes, then your client has investment interest and we’re right back to the Form 4952 and Schedule A. Your taxpayer/shareholder’s activity with the S corp also influences where the investment income deduction may be taken.
Passive Activity Interest
Perhaps the taxpayer borrowed against their principal residence to buy a rental property. That’s ok — it’s just not deductible interest for Schedule A. Rental activities are passive by definition so the interest is deductible against their rental income and taken directly on Schedule E.
Trade or Business Interest
Can taxpayers borrow against their principal residence and put the money into their business? Of course. But once again, they can’t deduct the interest on Schedule A. Money used for business purposes should result in fully deductible interest expense as a reasonable and necessary business expense.
Another thought…what if your client did use the money (including a HELOC) to buy, build, or substantially improve the primary residence and we have a bonafide business operating from the home? In this instance, I would argue to at least figure the traditional office in home deduction on Form 8829 as opposed to the simplified method. In the TCJA era, your client is likely to benefit more from “off Schedule A” deductions.
Just because your client received a Form 1098 mortgage interest statement from the bank doesn’t automatically mean the interest deduction goes on Schedule A. Talking with clients is even more vital in this age of indirect communication such as drop offs, e-mails, texts and instant messaging. Make sure the message isn’t lost in the dither of technology. This will provide a more accurate outcome for your taxpayer and who knows — -perhaps you’ll make new friends by communicating eyeball to eyeball.
by Tom O’Saben, EA
Originally published at https://taxschool.illinois.edu.