ALBUQUERQUE, N.M. — Q: I recently refinanced my principal residence and I now have a question about my ability to deduct the interest that I will pay. The home appraised for $650,000. At the time of the refinance I had $87,366 unpaid on my mortgage. The new loan is for $350,000. I used $145,000 of refinance proceeds to purchase a townhome in Scottsdale, Ariz., that my wife and I plan to use for 3 to 4 months each winter, and for occasional trips throughout the year. The townhome will not be rented when we are not there. We have invested the rest of the proceeds in fairly liquid investments, because we expect that we will need some added cash to help with living expenses of my father-in-law, who lives in Mesa, Ariz. Is this enough information to determine how we report interest expense?
A: It should be enough information, and your answer may change over time as you use the investment proceeds for specific expenses. The tax law generally classifies interest by “tracing” loan proceeds, so let’s go step by step through that process.
Right now I believe you have four separate interest classifications for your $350,000 loan. As I noted, generally one traces loan proceeds to specific uses to determine classification.
One exception to tracing is for residence interest. If the loan is secured by a qualified residence, interest may be classified as residence interest even if the loan proceeds are used for some nonresidence purpose.
I will have to assume that your old loan was used to acquire your principal residence. Such a loan is called “acquisition debt,” and its interest is deductible up to $1 million of loan principal.
When you refinance an existing acquisition loan, the new loan is classified as acquisition debt up to the amount of the refinanced acquisition debt. This means that $87,366 of principal on the new loan remains acquisition debt.
It may seem that $145,000 of additional debt is acquisition debt, since that is the amount used to purchase the Scottsdale property. However, to be acquisition debt, the loan must be secured by the residence that was acquired.
Your loan is secured by your principal residence, and not by the Scottsdale townhome. So the $145,000 cannot be acquisition debt. Because the townhome will be sued for personal, and not investment, purposes, the general rule is that the $145,000 creates personal, and nondeductible, interest.
But there is another residence interest classification that will offer some relief. Interest on as much as $100,000 of principal may be deducted as home equity debt. Home equity debt must also be secured by a residence, but the security may be any residence.
So at this point you may deduct interest on $187,366 of principal as residence interest, which is reported on schedule A of your return. This is $87,366 of refinanced acquisition debt and $100,000 of new home equity debt.
I will estimate that you deposited $117,634 (the $350,000 loan minus the sum of $87,366 and $145,000), although I suspect that closing and related costs may have reduced that figure a bit.
Deposited funds will create investment interest until spent (and then traced) for other purposes. Investment interest is deductible to offset investment income. You file IRS Form 4952 to show how much investment interest is deducted, and any amount in excess of investment income will be able to be deducted in future years, when you have more investment income.
So at this point you should have deductible interest on all but $45,000 of principal, which is the excess of the funds used to acquire the Scottsdale property over the allowed $100,000 home equity limit. This is nondeductible personal interest.
Had you used a separate acquisition loan for the Scottsdale property, secured by that property, all of your interest would be deductible in some manner.
Using my estimate of deposited loan proceeds, you should end up with 53.5 percent ($187,366/$350,000) of the interest deducted as residence interest, 33.6 percent ($117,634/$350,000) as investment interest, and 12.9 percent ($45,000/$350,000) as nondeductible personal interest.
These percentages should remain constant until you use the invested loan proceeds for some specific purpose. At that time, you trace the cash, and you may convert some investment interest to personal interest.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.