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Using equity from town house to buy new home

Dear Tax Talk,
Around the middle of 2005, my wife and I purchased a single-family home in our community. We had been living in a town house I'd owned for six years (in the same town), and the birth of our first child caused us to want a bit more space. The town house mortgage had been paid off, and to finance the new single-family home I took a HELOC on the town house, and we took a mortgage on the single-family home.

We did not want to sell the town house since we wanted to try our hand at being a landlord and rent the town house for income. We moved into the new house mid-year and a tenant moved into our town house in December. For tax year 2005, I believe the HELOC interest (secured with the town house, which is now a rental property) and mortgage interest (secured with our primary residence) are tax deductible, since the town house was our primary residence for around half a year.

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For tax year 2006 and forward, what are the tax implications of the HELOC interest, which is secured by a rental property? Since the HELOC secured by the rental property was used to purchase our new home, is it still possible to include it on Schedule E as an ordinary and necessary expense on the rental home, along with the depreciation and other costs?
-- Paul

Dear Paul,
For you to take a home mortgage interest deduction, your debt must be secured by a qualified home, which means your main home or your second home. If you have a second home, such as the town house, and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10 percent of the number of days during the year that the home is rented at a fair rental price, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. Therefore it would not qualify for the home mortgage interest deduction. At the time you put the town house up for rent in 2005, it ceased to be a second home for purposes of the home mortgage interest deduction, even though it was not actually rented until December.

Since you took out the mortgage on the town house for a personal expenditure, the interest is not deductible for tax purposes. You would only include on Schedule E interest related to carrying the property or improving it. Since there is no debt on the property, you would not include any interest on Schedule E. Your cost for depreciation purposes would be the lower of your original cost or fair market value at the time you rented the property.

Since you lived in the town house for six years, I assume that it has appreciated in value. Since this appreciation would escape tax if you sell it (using the $500,000 exclusion on the sale of the home) you may want to consider a sale before you go beyond the time limits. Remember, that in order to qualify for the home sale exclusion, the property had to be your primary residence for two years within the last five years. In your case this would mean you would need to sell by mid-2008 to still claim the exclusion.

Bankrate.com's corrections policy -- Posted: Jan. 6, 2006
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