Finding the capital to make investments, whether into your business or other traditional investments, can often be challenging. The more stringent lending rules emanating from the latest economic downturn have made it even more difficult. For many investors, the equity in their home represents a significant source of untapped wealth that might be available to fund capital needs. Currently, individuals who borrow against the value of their homes receive an income tax deduction (up to certain limits) for the mortgage interest they pay.
However, with the passage of the Tax Cuts and Jobs Act of 2017 (“TCJA”), the amount of debt on which mortgage interest is deductible has been reduced and the interest deduction on home equity indebtedness has been eliminated. Although the reforms restrict what interest is deductible as qualified residence interest, the interest tracing rules in the Internal Revenue Code (the Code) might provide a mechanism to borrow funds from the equity in your residence to fund investments and still receive an income tax deduction for the interest.i
To better understand how the interest tracing rules work, we will first review how the main categories of interest are treated for income tax purposes, paying particular attention to the changes coming from the recent tax reform.
Background – The 5 Main Categories of Interest Expense
There are five main categories of interest, each with different rules for tax deductibility.
Qualified Residence Interest
Qualified residence interest expense has undergone considerable changes due to the Tax Cuts and Jobs Act of 2017, becoming more restrictive than prior law. Currently, all individuals are allowed an itemized deduction on Schedule A for “qualified residence interest expense.”ii Qualified residence interest refers to the cost of interest on “acquisition indebtedness.” Acquisition indebtedness, commonly referred to as an initial mortgage, is debt that is secured by a “qualified residence” – your primary and one other residence – and is used to acquire, construct or substantially improve the residence. Under TCJA, interest expense is deductible on acquisition indebtedness up to $750,000 in total ($375,000 if married filing separately). This represents a significant reduction from prior law as interest expense was deductible on mortgage debt of up to $1 million in total ($500,000 if married filing separately). Although the debt limit for deductible interest has been reduced, mortgages secured prior to December 15, 2017 have been grandfathered under the prior limitations.
The same provision extends to refinancing an existing mortgage, given certain conditions are adhered to. If refinancing an existing mortgage that qualified as acquisition indebtedness, the refinanced debt amount must be equal to or less than the outstanding principal balance on the existing mortgage. Any refinanced debt in excess of the existing mortgage is not considered acquisition debt and thus is not deductible as qualified residence interest. Similarly, if the refinancing lengthens the loan term of the existing debt, any interest on the refinanced debt that occurs after the expiration of the original mortgage term will not be considered qualified residence interest.
Another change to qualified residence interest is in respect to home equity indebtedness. Home equity indebtedness is debt secured by a qualified residence, but not used for the purposes described under acquisition indebtedness. This type of debt is commonly referred to as a home equity loan or home equity line of credit (“HELOC”). Based on the new rules in the TCJA, interest deductions on home equity indebtedness have been suspended and no longer qualifies as an allowable deduction under qualified resident interest. This contrasts with prior law, where interest expense was deductible on home equity indebtedness up to a maximum of $100,000 of debt, but limited to the amount by which the fair market value of the residence exceeds the acquisition debt on that residence. Unlike acquisition indebtedness, existing home equity indebtedness does not have a grandfather provision.
Note that in order to deduct interest as qualified residence interest the debt must be secured by a qualified residence.
Business interest is interest incurred on debt that is used to finance the operations of a trade or business. The interest expense is a business deduction that is taken on the appropriate business schedule (e.g. Schedule C or Schedule E).iii Previously an uncapped deduction, the Tax Cuts and Jobs Act has limited the deduction of business interest. The deduction for business interest is now limited to the sum of its business interest income and 30% of adjusted taxable income. The limitation does not apply to small business taxpayers, which are defined as those with average annual gross receipts of $25 million or less over a trailing 3-year period. To counteract this change, any unused business interest in a tax year can now be carried forward indefinitely.
Passive Activity Interest
Passive activity interest is interest expense incurred in a trade or business in which the taxpayer does not materially participate. The deduction is subject to the passive loss limitation rules and is taken, as allowable, on Schedule E.iv
Investment interest is interest incurred on debt that is used to purchase property that is held for investment. Property held for investment is generally any property that generates portfolio income such as interest, dividends or royalties. The deduction for investment interest is limited to the amount of net investment income generated in the tax year and is taken on Schedule A.v Any unused investment interest in a tax year can be carried forward indefinitely.
Personal interest, commonly referred to as consumer interest, is interest not otherwise classified above. Examples of typical personal interest include debt used to purchase any personal, non-business, non-investment property. Personal interest is not deductible.vi
The Interest Tracing Rules
The Regulations under Internal Revenue Code (“IRC”) Section 1.163-8T define the method for allocating interest in order to apply the appropriate deduction limitations for passive activity interest, investment interest and personal interest and are commonly referred to as the “interest tracing rules.” These rules do not apply to the deduction for qualified residence interest. The qualified residence interest rules as outlined above define the security interest (the qualified residence) and use of proceeds rules in order to determine the appropriate deduction.
Allocation of Interest: Use of Funds is Most Important
The most important determining factor contained in the interest tracing rules is the use of the debt proceeds. Unlike the qualified residence interest rules, the security interest for the debt is not relevant when applying the tracing rules. The only relevant factor is what the proceeds are used to purchase. For example, if you took out a loan that was secured by business assets and used the funds to purchase a boat or other personal asset, you might believe the interest is deductible business interest. However, it is actually non-deductible personal interest under the interest tracing rules since the proceeds of the debt were used to buy a personal asset. Since it is the use of the debt proceeds that is determinative, these same rules can be utilized to convert what may be otherwise non-deductible interest into deductible interest.
Even with the mortgage interest deduction substantially reduced and the elimination of home equity indebtedness under the TCJA, there may still be a way to obtain a deduction for the interest on the mortgage or home equity loan. If you were to take out a mortgage or a HELOC secured by your residence and used the proceeds for another purpose such as to fund trade or business operations or to purchase an investment asset, the interest could become deductible, subject to any limitations of that interest category.
This is not applicable just to mortgages or home equity loans. You could apply the same logic across interest categories to obtain the most favorable results. Again, remember that the security (collateral) for the debt is not important; the use of the proceeds is the only relevant factor.
Make Sure You Are Able to Trace the Funds
What is of utmost importance when applying the interest tracing rules is the ability to clearly trace the funds from receipt of loan proceeds to disbursement of funds. If the loan proceeds are commingled with other funds, complicated rules come into effect in order to allocate the interest to the appropriate category. The best suggestion is to create a clear trail by opening separate accounts into which loan proceeds are deposited and from which funds are withdrawn to be able to identify the use of proceeds.
Now Might be a Good Time to Borrow
Given that mortgage interest rates are at or near all-time lows, now may be a good time to borrow against your principal or second residence in order to invest in a business or to make other investments. Although lending standards have increased in recent years, for those borrowers with excellent credit many banks are willing to make loans. Investigate the differences in interest rates between mortgage debt and business debt and also take into consideration the length of the loan term when making a determination of which type of loan is most efficient. Mortgages can have fixed rates for up to 30 years while typical business loans generally have much shorter loan terms.
Using the interest tracing rules outlined above and the equity in your home can result in a tax efficient way to invest in a business or to make other investments. As well, given current low mortgage rates, borrowing against the equity in one’s home could provide the least expensive funding.
The interest tracing rules can be quite complex and if the proper accounting and tracing is not maintained, the intended tax benefits could be lost. As is always the case with income tax planning, following the rules and documenting the transactions are most important to ensure the desired results are achieved.
i IRC Reg. Sec. 1.163-8T
iiIRC Sec. 163(h), et seq.
iiiIRC Sec. 162
ivIRC Sec. 469
vIRC Sec. 163(d)
viIRC Sec. 163(h)(2)