Bankrate.com

Wednesday August 15, 6:00 am ET
George Saenz

Dear Tax Talk:
I own a rental property that has no mortgage. If I refinance the property and use the cash to invest in other real estate or other investments, can I deduct the loan interest and expenses as investment expense? Or am I required to offset any loan cost against the financed property?
– Bill

Dear Bill,
We need to clarify some terms before I get to your question. Interest expense for tax purposes is divided into five categories:

1. Business interest, which is related to an operating business.
2. Investment interest, which is related to investments other than rental activities.
3. Passive activity interest, which is interest related to rental activities.
4. Home mortgage interest, which relates to a first or second personal residence.
5. Personal interest, which is none of the above and not deductible.

The use of loan proceeds determines the category of interest expense. Tracing rules exist to determine the use of your loan proceeds. If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.

If you refinance the debt-free property to buy another rental property, then the interest on that loan is deducted against the new rental property’s income. Overall rental activity losses are subject to current deduction limitations depending on your adjusted gross income or profession.

If you use the proceeds to buy stocks, then the interest is treated as investment interest. Investment interest is an itemized deduction and is only deductible against investment income. This generally includes your gross income from property held for investment (such as interest, dividends, annuities and royalties). It does not include qualified dividends (dividends taxed at the preferential 15 percent rate) or net capital gain unless you choose to include them. Use Form 4952 to claim an investment interest deduction. If you use your proceeds to buy tax-free investments such as municipal bonds, the interest is not tax-deductible.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.