Interest following debt purpose

[Margaret CPA in OH]

In 2005 a client mortgaged a rental property to purchase another.  I did some research at that time and have some notes that the interest follows the debt purpose so the mortgage interest was deducted on the second property.  That property sold a few years later and the client did not pay off the mortgage so, looking at my notes, I have considered the interest not deductible and advised them to pay off the mortgage.

My note says Rental Interest Notice 88-99, interest follows debt purpose, not the collateral, that is debt follows the property and, if building, then capitalize it.  I'm now struggling to find this again with clear verbiage to provide the client.  Anyone have this in your practice?

[jklcpa]

Yes, you are correct about allocating the debt and its related interest expense based on how the debt proceeds are used. It's in the interest tracing rules, and a general explanation can be found in Pub 535, chapter 4.  It's been a few years but I've had to deal with the interest tracing rules in the past.  My client actually had multiple properties that the proceeds were used for: an active rental, 2 separate pieces of raw land that remained undeveloped and were held as investments until sold, and there might have been a small amount of proceeds used personally, I don't remember.  I had a spreadsheet to track it all, but luckily for me, this particular client hates to have any kind of debt, so he paid off the loan as soon as he was able and I didn't have your complication when he finally sold those pieces of raw land.

What I think you should be looking at are the rules in Reg 1.163-8T. Start at the beginning, obviously, but I think your answers are specifically in paragraphs (j)(2) for the rules of reallocation that then reference back to paragraph (c)(4). Please also see example #2 under paragraph (j). (That's a lowercase J).  If I'm interpreting paragraph (j) correctly (a big IF) it seems like you should have reallocated the remaining debt at the time of the second rental's sale in proportion to however its sale proceeds were used, and possibly some of that interest might have been deductible after all, IF the client used it for another rental property, or an investment...anything but personal.  Read it and see what you make of it.  I'd like to hear how you interpret it and how you'll handle it on the return. (the added link to reg is safe, goes to law.cornell.edu)

If you want to read Notice 88-99, I googled that and found that it is a part of the Cumulative Bulletin 1988-2 that can be downloaded as a pdf at the U.S Govt Publishing Office at this website: https://www.gpo.gov/fdsys/granule/GOVPUB-T22-620cc5a588d849c91ff319f0315765f9/GOVPUB-T22-620cc5a588d849c91ff319f0315765f9-2/content-detail.html . That appears to be something to do with the Unicap rules.  That would probably have been in reference to your statement about if the interest is "if building", and by that meaning "constructing" or construction period interest. I don't think that would be relevant unless that second rental had some element where the interest was capitalized for a period of time.

Pub 535, ch 4 has a more generalized explanation the interest tracing rules, if you want to look at that.

Also, in searching for "tracing" on this forum, I found this conversation between you and Jainen that might jog your memory of why you handled the interest in a particular manner.

I hope some of my rambling is helpful.

 

 

Edited May 14, 2016 by jklcpa
added the link to the Reg left out of original post

[Margaret CPA in OH]

Judy, you are an absolute angel!  And to find my original post is amazing!  I had not realized that I looked at this before but that was likely when I made that note to self which I now found not so easily understandable.

I will very carefully reread all of this, especially Jainen's original reply.  I did find the Notice 88-99 but honestly couldn't match the text with the situation again but apparently did a few years ago. 

Good homework tomorrow.  And I will seriously revisit my threat of which Jainen reminded me. 

Thanks again and again!  And I've decided only 2 more tax seasons for sure and probably none for these folks.