Mortgage deduction limit when renting part of property

[cannedham]

We recently bought a house, and even after reading through the IRS codes I can't figure out how mortgage deduction limits work when you're renting a portion of your property and your mortgage amount is above $1 million. I'm trying to understand if it makes sense to pre-pay my mortgage or not. Any advice would be appreciated.

Situation:
- $1.28M mortgage @ 3.875% interest rate on a property with 2 structures. The main house, and a separate dwelling with a separate address that we are listing for rent.
- 39.6% tax bracket
- The rental property is approximately 20% of total property interior square footage. If I use interior square footage for valuation, this property should represent .2 * $1.28M = 256k of our mortgage.
- I think our main house and primary residence is thus worth .8 * $1.28M = $1.024M of our mortgage.

What I would like to do is pay down my mortgage until my mortgage interest is not pro-rated under the mortgage deduction limit. I believe all I need to do is pay off $30k early and have $1.25M on the mortgage left. I want to deduct 20% of the mortgage interest as a rental expense, and then I want to deduct 80% * $1.25M = $1M of the mortgage value for the main house. If I understand this correctly, I'd be able to deduct the maximum amount of my mortgage between my main house and the rental property since the main house mortgage value is less than or equal to $1M.

However, I haven't found any clear instructions on whether I can remove the value of the rental property from the mortgage amount to be under the mortgage deduction limit. If not, I'd have to pay off $280k -- money that I don't have to spend right now on the mortgage.

Does anyone know the answer to this problem? Thanks for your help!

[john94549]

You might want to check with a CPA on this. As I recall, if a home mortgage is used for multiple reasons, you allocate (as you have done). The wrinkle is how principal payments are applied. Again, this is just from recollection, but I believe principal payments are first applied to non-owner-occupied, non-principal-residence uses. So, if I'm right, the principal payments would reduce the allocation to the rental structure, but not the main residence. Stated another way, the $1.1 million of acquisition plus home equity (see below) would not be reduced until the principal payments equalled or exceeded the amount of the loan allocated to the rental ($180,000). This attribution sequencing is supposed to maximize deductible interest for most folks, since you pay down non-deductible consumer debt first, Schedule E debt next, then home equity/improvement debt, leaving the $1.1 million home mortgage debt interest (Schedule A) clicking right along.

The interest on $1 million is deductible as acquisition financing.The interest on $100,000 should be deductible as interest on home equity debt (see IRS Pub 936). In effect, the limit is $1.1 million ($1 million plus $100,000 home equity). I don't know whether the $1.1 million can be increased by additional debt incurred for actual improvements in the future. Check with your CPA.

You can use home equity debt for the purchase of cars, boats, furniture, even rental property. The 80/20 would be used for costs (rental expenses) you need to allocate, other than interest (real property taxes, for example).* The interest on $1.1 million goes on Schedule A. The interest on $180,000 goes on Schedule E. Note: if you are a high-earner, under the new tax law, it might be better to allocate more to Schedule E and book it. Check with your CPA.

FWIW, I first became aware of all this many years ago, when we did a cash-out re-fi on our principal residence and used the proceeds (in part) to pay off the loan on our rental condo. Approximately 60% of the proceeds was allocated to principal residence (acquisition loan, improvements and $100K home equity) and 40% to the condo. As we have paid down the loan, the numerator assigned to the principal residence has remained constant, while the denominator has fallen (the amount owed). Once the amount owed equals the acquisition loan, improvements and $100K home equity (i.e., the condo allocation is "paid off"), the allocation of interest will be 100% to Schedule A and 0% to Schedule E.

*Since you have one "property" that's "two properties" for tax purposes, you will need to review the various expenses on Schedule E. You might receive but one bill for insurance, PG&E, gardening, water, sewer, property tax, etc. You will incur expenses deductible (in part) on Schedule E although not deductible on Schedule A. Depreciation and capital gains can get tricky. Best to use a tax pro.

[cannedham]

Thanks, john, for the pointers. Sounds like talking to a CPA is a good idea.