Here is a “nutshell” approach to figuring out how each kind of real estate interest (excepting your personal residence) is classified for tax purposes and how each is treated on the tax return.
There are three major classifications of interest on the Federal individual income tax return. Each classification is subject to different rules. Because of this, great care must be given to determine the correct classification of each interest item. It’s the only way to figure what is deductible and where to deduct it.
1. Business interest
(a) Interest on rental income real estate
(b) Interest on business indebtedness
2. Investment interest
3. Personal interest
(a) Consumer interest
(b) Qualified residence interest.
Borrower's Cost of Getting Loan
Borrowers may incur substantial fees and charges when a mortgage loan is funded. These costs include legal fees, "points", appraisal fees, escrow fees, service charges, surveys, real estate commissions and title costs. These financing costs must be analyzed and divided into two categories:
1. Costs that do not qualify as interest.
2. Costs that do qualify as interest.
Costs That Do Not Qualify As Interest
Costs that do not qualify as interest are treated as lending service costs. If the mortgage was obtained to acquire real estate used in business or held for profit, the costs are deductible by amortizing them over the life of the loan. If the mortgage was obtained to acquire real estate held for personal use, lending service costs are not deductible.
Amortization of loan costs is always taken using the straight-line method. Amortization is continued until all costs are written-off or the loan is paid off or assumed. If there is a balance in the unamortized loan costs account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. In cases of rental income and other business property, the balance is deductible as an operating expense of the property.
For example, 10 years ago you bought an apartment house and paid loan costs of $20,000 to acquire the 25-year mortgage loan. You now sell the property as part of a 1031 exchange. During the last ten years you deducted your loan costs by amortizing them at the rate of $800 per year ($20,000/25 years). Your deduction totaled $8,000 for the ten years ($800 per year times 10 years). The unamortized balance of $12,000 is deductible at the time of the sale as an operating expense of the property. Do not take it as a selling expense of the property - if you do, you could lose the entire deduction.
Costs That Do Qualify as Interest
Costs that qualify as interest are treated as prepaid interest - capitalized and amortized straight-line over the life of the loan.
The term "points" is used to describe the interest charges you pay as a borrower to a lender when you take out a mortgage. Lenders have different names for points: loan origination fees, premium charges, etc. But what they call them doesn't matter. If the payment for any of these charges or points is for the use of money, it is interest.
Charges or points paid for the use of money are deductible as mortgage interest. They are treated as prepaid interest and subject to the prepaid interest rules. Amortization of points is figured using the straight-line method and is continued until the points are all written-off or the loan is paid off or assumed. For example, if you are charged $2,000 interest points for a 20-year loan, the $2,000 is considered prepaid interest. Under the prepaid interest rules, you must spread your interest deduction over the tax years in which it belongs. In other words, you can only deduct in each year the interest expense for that year. $2,000 prepaid interest for a 20-year loan must be deducted over 20 years at the rate of $100 per year.
If there is a balance in the unamortized points account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. For rental income and other business, the balance is deductible as an operating expense of the property. For your personal residence, the balance is deductible as qualified residence interest, if otherwise qualified.
An easy to determine what kind of interest you are dealing with is this simple rule:
Interest deductions follow the money. Just ask this question for each interest amount - where did the money I'm paying interest on go? That's where the deduction goes. For example, you borrow money to buy a computer for your business. The interest is business interest - that's where the borrowed money went. Here’s another familiar example. You borrow a hard-money second nd on one of your rental properties and use the money to buy a new personal automobile.
Is the interest deductible? If yes, where do you deduct it? If not, why not?
Just ask the question -where did the money go? Since the money was used to buy a personal asset, the interest is not deductible. Wait a minute, you say. I borrowed the money on my rental property. Why can’t I deduct it against my rental property as an operating expense on Schedule E? The collateral has nothing to do with the use of the money you borrow so don't let it get in your way. The test is: Where did the money go?
Loan proceeds used to acquire:. ->Interest is deducted as:
Rental Property......................................->Rental Expense
Investment Property.............................->Investment Interest
Personal residence..................................->Itemized deduction (if qualified)
Farm property........................................>Farm expense
Dealer property......................................>Business Expense
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