Loan Tracing Question

[Corduroy Frog]

Married Tennessee taxpayers own a house in Memphis, mortgage free with no interest.  Also owns a primary residence in Nashville, encumbered with mortgage and interest.  For purposes of illustration, assume the taxes on both houses, interest on their primary residence, and contributions total $29,001, meaning their itemized deductions are next virtually without tax benefit.

Nashville is a boom town, and Memphis has become the crime capital of the USA, so they can't sell their house in Memphis.  Nobody wants to buy in Memphis, everyone wants out.  So......here is their plan.

Put the Memphis house into an LLC and begin renting it out.  The LLC deductions will be property taxes, depreciation, repairs, and little of anything else.  They would like to also deduct interest but have no mortage.  So they can borrow money against the Memphis home, and with the proceeds pay off the Nashville mortgage which was not helping them anyway taxwise.

Since the Memphis house in the LLC is now mortgaged, can the LLC deduct the interest expense?  (assume the LLC makes the choice of entity, for example a partnership).

Or will the "tracing" rules prevent it?  My guess is yes they can...but would love to hear from some of you...

 

 

 

 

[Lee B]

It doesn't meet the definition of Acquisition Debt, Home Equity Debt or Refinanced Debt.

[Gail in Virginia]

Just wondering if the LLC involved more members, such as children of the taxpayers, and the LLC borrowed money to buy the property from the original taxpayers, then it would be acquisition debt.  Of course, the taxpayers would have to pay taxes on any gain on the sale of the property.  And since it would be a related party sale, they could not deduct any loss due to the reduced market values in Memphis.  I am NOT recommending this - more like thinking of possibilities.