Examples of IRS Interest Tracing Rules
The best way to understand IRS interest tracing rules is by example. The following are a variety of situations to help understand the application of the tracing rules.
Example 2: A taxpayer refinances an existing loan ($150,000 amortized balance) secured by his rental property for $200,000 and uses the excess proceeds to buy for $50,000 a car for personal use. The taxpayer must trace the use of the refinanced loan proceeds (“allocate the proceeds”) to the portion used to pay off the existing amortized rental loan of $150,000 and the $50,000 portion, used to purchase the car. The loan interest expense is then proportionally allocated between rental interest ($150,000/$200,000 = 75%) and personal interest ($50,000/$200,000 = 25%) for the purchase of the car. So, 75% is related to the rental property and 75% of the interest is deductible on Schedule E, and 25% is non-deductible personal interest. Note: it does not matter that the new loan is secured by the business property; the interest allocated to the personal use of the loan proceeds is not deductible.
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Example 3: The taxpayer wants to acquire an additional rental, so she refinances one of her existing rentals to obtain the down payment. Here the tracing rules are used to trace the use of the funds. The interest on the refinanced loan must be allocated between the portion of the refinanced debt used to refinance the existing rental loan and the portion of the debt used to acquire the new rental. Thus, the interest is proportionally allocated between the two rentals.
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Example 4: The taxpayer borrows $50,000 secured by his home to be used as working capital in his consulting business. He has no other debt on his home. He deposits the $50,000 into a checking account that's devoted to his business, and he uses the money in that account only for his business.
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For years before 2018 and after 2025 – He must deduct the interest as home equity debt interest on his Schedule A since the debt is secured by his home and the debt is less than the $100,000 limit for equity indebtedness. However, the election to unsecure the debt from the home could have been used, in which case the interest on the debt would have been traceable to the use of the loan proceeds.
For 2018 through 2025– He must trace the use of the funds and since the loan proceeds were used in his business, the interest is an expense of the business.
Example 5:The taxpayer owns a rental property and wants to purchase a personal residence. So, he obtains a loan on the rental to refinance the existing amortized acquisition debt of $40,000 and to purchase the personal residence for $160,000. Under the tracing rules the taxpayer must trace the use of the refinance proceeds to its uses. Since $40,000 of the new debt was used to pay off the debt related to the rental property, the character of $40,000 of the new debt takes on the same character as the old debt. The $160,000 balance of the refinance proceeds is traced to the purchase of the taxpayer’s home. However, the definition of home acquisition loan debt requires the debt to be secured by the home, which it is not. Thus, the interest on the $160,000 portion of the refinanced debt is not deductible.
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Example 6: The taxpayer wants to purchase a lot and build a rental on it. He plans to purchase the lot with cash savings and then build the house with a construction loan. Once the construction is complete, he intends to refinance the construction loan with a take-out loan and use part of the debt to restore the savings account for the funds used to purchase the lot. Under the tracing rules he must trace the interest based upon the use of the refinanced loan proceeds. The portion of the loan used to refinance the construction loan can be traced to the rental, and thus is deductible as rental interest. The portion reimbursing the taxpayer for the cost of the lot must be traced to the use of those funds, and assuming the taxpayer banked those proceeds, that portion of the interest would be treated as investment interest.
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Example 8: Taxpayer purchases a property he intends to use as a rental. The property is in such bad condition that he cannot obtain a loan. So, he purchases it with cash from his savings and fixes up the property, also using cash from his savings. When the work is complete, and the property is available for rent, he finances the rental and deposits the proceeds in his savings account. Following the tracing rules, we trace the use of funds to determine if the interest is deductible and where. In this case funds were deposited in the taxpayer’s savings account and as a result the interest on the loan becomes investment interest. But that is not the end of the story. Since the proceeds of the loan are now in the taxpayer’s savings account, if he subsequently uses some of those proceeds (takes money out of the savings account) and uses it for another purpose, we again have to trace the use of the savings withdrawal to follow the money. If used for a personal purpose the interest on that portion of the loan is not deductible. If used for a business purpose then the interest on that part of the original loan would become business interest. As you can imagine, this would become a tracing recordkeeping nightmare.
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Example 9 - Special rule that only applies to first and second homes: The taxpayer has an opportunity to purchase a home in a quick sale and does not have time to obtain financing and make the purchase with cash. Then after escrow has closed, he obtains financing for the home. Notice 88-74 states that where a taxpayer is purchasing a residence, the debt may be treated as incurred to acquire the residence (“acquisition debt”) to the extent of expenditures to acquire the residence made within 90 days before or after the date that the debt is incurred.
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