Using a HELOC to buy rental property

Dear Tax Talk,
My wife and I built our primary residence two years ago and do not have a mortgage on it. We have taken out a HELOC and are using the credit line to purchase several investment (rental) properties. Since we can directly trace the use of these funds to the purchase of the rental properties, is our deduction limited to $100,000 of equity debt? What if we also use some of the line for personal debt? Does that affect the deductibility in any way? Thanks. -- Bob

Dear Bob,
A quick note for our readers who may not know: HELOC is a home equity line of credit. There are a couple of ways you could treat the interest on your HELOC, but first let's look at all the options.

Interest paid falls into six categories:

1. Investment interest
2. Trade or business interest
3. Passive activity interest
4. Home mortgage interest
5. Student loan interest
6. Personal interest

Investment interest is interest paid to carry an investment that produces interest, dividends or the sale of which results in capital gain. A typical example is margin interest paid to your broker. The interest is deducted on Schedule A subject to investment income limitations.

Trade or business interest is interest paid relating to a business carried on by the borrower. A typical example is interest on a bank loan used to finance equipment used in a Schedule C activity.

Passive activity interest is interest paid by the borrower to finance a passive activity. A passive activity is generally a rental activity such as rental real estate reported on Schedule E.

Interest paid on a mortgage secured by your primary or second home is deductible as home mortgage interest (reported on Schedule A), but there are a few basic restrictions. If the mortgage debt is used to acquire your primary home or a second home used for personal purposes, the interest is deductible as home mortgage interest. The acquisition debt for both homes cannot exceed $1 million.

If the mortgage was not used to acquire the home or traceable to one of the first three activities (that is, the debt is incurred for any other reason), the amount of deductible interest cannot exceed the interest paid on $100,000 of debt plus the amount of any substantial improvements made to the home. Another limitation is that you cannot deduct interest on home equity debt if you use the proceeds of the mortgage to buy securities or certificates that produce tax-free income.

Student loan interest is interest you pay on debt used to for higher education expenses for yourself or a dependent. Student loan interest is deductible up to $2,500 as an adjustment to adjusted gross income and subject to phase out as income increases.

Personal interest is all other interest paid and is not deductible. For example, interest paid on credit card debt that was not used for any of the first three activities.

When you borrow funds, the funds and related interest are traced to activities that utilized the funds within 30 days of the borrowing. In your case, all your borrowings on the HELOC were used to acquire rental property. Therefore, the interest paid on the debt could be considered passive activity interest or alternatively you could treat it as home mortgage interest within the $100,000 limitation or a combination thereof.

If treated as passive activity debt, the interest is deductible against the rental income produced by the acquired property. The limitation of $100,000 on home equity debt does not apply, as the debt was not incurred for personal purposes.

If you use part of the HELOC for personal purposes, that interest would be allocated to home mortgage interest on Schedule A within the $100,000 limitation.