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Posted by eagent on September 11, 2007, 4:41 pm
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> I need some Tax Advice for rental property. My primary
> residence is in Va. I paid off my home last month and it is
> valued at about 250k. I also own a rental and it is valued
> at about 140k. I currently owe 4500 on it and it will be
> paid off next August.
>
> I am thinking about buying a second rental for 170k. I am
> not sure the best option for financing it. My credit is
> excellent. Here are my options:
>
> Option A: I can finance 80% of the 2nd rental (135k) @ 6.3%.
> I can then do a cash-out refinance of my first rental
> property for 35k at 6.3%. The positive side of this is that
> come tax time, I can take the standard deduction since I own
> my primary residence free and clear. I can also deduct all
> my mortgage interest paid on my "Schedule E" thus I am
> writing off interest against my rents received. Another
> positive is that my home has nothing against it thus it is
> somewhat safe in case of a major catastrophe. The negative
> side of this is that I would be doing two closings since I
> am using two properties to come up with the 170k and the
> interest rate is 1/2 point higher since it is investment
> property.
>
> Option B is for me to take out a mortgage for 170k from my
> primary residence. The positive side of this is that I can
> get the loan at 5.8% instead of 6.3 because it is my primary
> residence and not an investment residence. I would then own
> two rental properties free and clear. The negative side
> would be that there are no interest that can be deducted
> from the rents received on the "Schedule E" I would have to
> itemize and I could only write of the interest against my
> primary residence, thus the Standard Deduction would no
> longer be available to me. Another con is that I now owe
> money against my primary residence and in case of a
> catastrophe, I could loose my home.
>
> My yearly income from wages would be about 50k not counting
> rental income My first rental would rent for about 800 per
> month My second rental would rent for about 1200 per month.
>
> Please provide any additional insight that I may be missing.
> Also, please advise any tax issues if known and recommend
> weather you think I should go with Option A or Option B.
You have a fundamental misunderstanding of the "Tracing
Rules" for mortgage interest. If it's any consolation, I
have yet to meet a civilian (non tax pro) who understood
them - Sadly, I've met far too many tax pros who either
don't understand them either or fail to apply them.
The Mortgage Interest Tracing Rules REQUIRE you to trace the
usage of the mortgage money and report the interest expense
on the most appropriate form. So in in either of your
examples you need to allocate the interest between the two
rentals and claim the mortgage interest on the appropriate
Schedule E.
In your option A, even though you have two properties
mortgaged, the interst on the $170K goes on Property B and
the interest on the remaining $4,500 from property A stays
on property A - EVEN though you've mortgage property A to
buy property B.
In your option B the mortgage interest would get reported on
Schedule E for property B. Otherwise, you'd be limited to
deducting the interest on NO MORE than $100K - this is the
deductibility limit on home equity loans. Since you have no
mortgage on your home if you borrow $170K you can only
deduct the interest on the first $100K on Schedule A anyway.
Compound this with the Alternative Minimum Tax Requirement
that you add back the Home Equity Interest when you
recalculate your AMT and you'll find that you get very
little benefit from putting the mortgage interest on your
Schedule A.
BUT since we are required to trace the use of the funds and
the funds were used to buy a rental ALL of the interest can
go on Schedule E so don't have a deduction limitation and
you will likely avoid the AMT trap altogether.
Whether you use Option A or B is a decision that is not just
a financial one. You don't give us enough information to
make a real tax recommendation, that would take a lot more
info - your age, marital status, state, tax bracket, etc.
However, I agree that not having your home encumbered is a
big (NONFINANCIAL) plus - I like this. This is a vote for
Option A.
But considering you'll get an above the line tax benefit
either way, paying less is always better than paying more.
So this is a vote for Option B.
I would recommend you consult with a local tax pro with real
estate experience AND a local real estate attorney in your
locality and see about:
Setting up LLCs to hold the rentals - this could help limit
your personal liability; Using Option B to loan the money to
the LLCs that hold the property - you may be able to
encumber them with a mortage from YOU!, but you really need
legal guidance on this. I do NOT know if this will work.
Good luck,
Gene E. Utterback, EA, RFC, ABA
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