Refi of mortgage, repay private loan

[Margaret CPA in OH]

Clients borrowed money from family (appropriate interest terms but not deductible as personal loan not secured by property) in Germany.  In 2020 they refinanced the property having made extensive improvements including a rental apartment.  The much higher value permitted a refi sufficient to repay family loan with cash out as well as complete additional major improvements. 

Rental property is 39% of property value overall - it's been, um, interesting keeping track of what costs went where. Normally on a refi of rental, some items would be added to the basis, some would be amortized over the loan life, some would be deductible.  Is it correct to allocate to the rental portion these refi charges at the percentage of property value?

And what about that part where the funds taken out should be used to improve the property?  I'm thinking, in a sense, the private loan payback does that as the original was used to improve the property and they couldn't even get any deduction for the market rate interest they were paying.

Thoughts? (At least this isn't unemployment insurance or PPP loans, amiright?)

[Lee B]

Margaret, I must say you have the most interesting clients

[jklcpa]

I would follow the interest tracing rules and the ordering rules for repayments, both of which are outlined in 1.163-8T.  

https://www.law.cornell.edu/cfr/text/26/1.163-8T

[Margaret CPA in OH]

Yes, I do have several interesting clients among many more 'normal' ones.  I don't recall how I got the German folks many years ago but, through their university teaching positions, I seem to have become THE person to contact and, in fact, received another referral just yesterday. 

The AU folks were originally here so they don't count but are getting more interesting now that both children have graduated and are on their own.  The daughter is a successful freelance illustrator working virtually.  She was quite dismayed learning about self employment tax and began asking her mother about renouncing her US citizenship to avoid it.  We will see how that goes.  No income tax due to the exclusion but SE tax just like her father's when he lectures or consults.

Thanks Judy, I will pore over that to refresh my memory.  I have had to do, um, interesting tracing for another client before when they mortgaged one property to pay to purchase and remodel another.  I encouraged them to mortgage the second property as soon as possible.  They also took out a LOC loan for their own home and a rental.  Ah, the spreadsheets...