Today TaxMama hears from Karen in the Tax Quips Forum, with a complex problem. “Her client owns three homes: A primary home, a vacation home and a home for Mom. They bought the vacation home with a mortgage. After paying cash for their residence, they refinanced it buy Mom’s home. The question is – can they deduct the mortgage interest on their residence, even though it was used to buy Mom’s home? If not, can they deduct it as investment interest?”
Dear Karen,
Under the circumstances, the mortgage on the personal residence is not considered acquisition debt, since it was not used to buy or improve the home. Unfortunately, the interest deduction is limited to the interest on $100,000.
David Toelkes explains the various options when it comes to deducting interest expense on real estate, and how improvements, and use of the funds comes into play.
They would have been better off holding on to the cash when they bought their home. If they had gotten a mortgage on that, it would have been fully deductible (limited to a loan of $1 million + $100,000, of course.)
As to using the interest expense as investment interest? That’s not as easy as you think.
1) As David said, the deduction for investment interest is limited to your investment income (typically, dividends, interest and capital gains).
2) When you use investment interest, it can change the tax rate on your qualified dividends and capital gains. Instead of having a maximum tax rate of 15%, they get taxed at your highest tax rate. Of course, if you don’t have any qualified dividends or capital gains, that’s not an issue.
Incidentally, there is a little bit of good news about investment interest – any interest you cannot deduct is carried forward – forever. Until you have investment income to offset it.
What is your best bet in order to use as much of the interest deduction as possible?
Use the interest on the first $100,000 as mortgage interest. Use the rest of the interest as investment interest. At least if you have investment income in the future, the interest will be there to offset it.
And remember, you can find answers to all kinds of questions about interest expenses, and other tax issues, free. Where? Where else? At www.TaxMama.com.
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