Tax Deductability on Mortgage Interest

Something came up in a IMHO thread which I wanted to discuss/get some info about.

In the US, you can claim the interest costs on the loan on your primary place of residence as a tax deduction (I’ve known this for a while), but I just discovered from the thread I mentioned that you cannot claim the interest costs for the loan on a rental property. (If you’re not an active property investor).

I find this interesting, because in Australia it is exactly the opposite. Interest on your home loan for your PPR is non-deductible, but the interest (plus other costs) on an investment property are tax deductible, and in fact are so prevalent that there is an entire investment strategy called Negative Gearing where you purposely take a net loss on an investment property to gain a tax advantage. (Was a much more useful strategy pre-GFC when property prices had increased year on year for decades).

I’m wondering what the policy intention is behind the US structure? Presumably it makes it easier to buy your own home? But discourages many people from being ‘small-time’ property investors, with just one or two investment properties?

There’s also a concept of “business” versus “hobby” losses in US tax law. Losses on hobbies (e.g. creating art and selling it occasionally in your spare time) is subject to serious restrictions on deducting losses, and losses may not be deductible at all. However, if you are a bona-fide self employed artist, then losses are fully deductible. If you could fully deduct hobby losses, then you could go have fun and deduct your entertainment costs, then make some token effort to make a little money off of what you love to do and reduce your tax liability.

e.g. you could spend thousands on a gaming PC, then claim that you bought it as part of an effort to win money in a video gaming competition, which you lost or failed to qualify for, therefore your endeavor saw a loss. But that would be basically saying that you can deduct money you spent on games.

just popping in to comment on the juxtaposition of the OP title and the OP’s nickname.

I think you can deduct interest on up to two homes - because Congress, who voted it in, generally maintain two homes.

The home mortgage deduction was established years ago with the idea that home ownership was something to be encouraged and thus a tax break would allow more people to buy homes.

I’m confused by this. No one is going to buy properties and rent them out as a hobby - are interest expenses for a property you’re renting as a business actually not tax-deductible?

Basically you can deduct the interest for rental properties.

Is the premise of the OP incorrect then, or is there a subtlety I’m missing?

Let’s differentiate between four different cases:

  1. Personal interest.
    It used to be, many decades ago, that all personal interest was deductible. That included credit cards, personal loans, department store revolving credit accounts, etc. Congress eliminated this deduction, but left in place the ability to deduct personal interest on your primary residence and one other residence.

So, if in addition to your primary residence, you have a mortgage loan on a summer villa and a winter ski chalet that you use for your own personal pleasure, you will have to choose whether to deduct interest on the villa or the chalet, but not both.

  1. Rental property. You may deduct mortgage loan interest on a rental property. It’s right there on line 12 of Schedule E. This is separate from (and in addition to) the personal interest deduction described above.

However, if the end total of all of your income and expenses (including interest) from the rental property is a loss, the loss is subject to the passive activity loss limitations. See “Passive Activity Loss Rules” on page E-2 of the Schedule E instructions. These rules may require you to delay claiming some of the loss you incurred until you dispose of the property. Note that this is not specific to the loan interest, it applies to the overall loss on the rental activity.

  1. Investment property.
    If you buy real estate and hang onto it hoping that it will increase in value but do not make personal use of it, like you might buy stocks for example, then you can claim an itemized deduction for investment interest on Form 4952 which is then carried forward to Schedule A.

  2. Business property.
    If you are paying interest on a property you own for your business (for example, a factory or shop), you would list the interest as a business expense on Schedule C, Form 1065, or Form 1120, depending on the structure of your business.

Let’s say I go out and buy a condo right now. My monthly interest is 1400, my monthly taxes are 200, my monthly principle is 250, and my monthly condo dues are 150. Everything starts on 7/1, let’s say. I never intend to live there - this is all for my real estate business. I also start renting the place on 7/1 for 1500. So I get 9000 in 2011 in rental income, I pay 9600 in interest and taxes (do I also get to deduct condo fees as a business expense? I know I can’t for my residence.) So I take a loss of (at least) 600 for 2011, which I’m happy to do, since I am getting appreciation (let’s be optimistic.) So I can’t offset my normal income with that 600, but I can carry it forward into 2012, when I sell the place for a net capital gain of 10000, and offset it against that gain? Did I get that roughly right?

The premise of the OP is incorrect, but it’s a little subtle. The interest is not deducted as mortgage interest, but as business expense. It’s part of the calculation of how much of the rental business income is taxable.

Condo fees for a rental unit are deductible, because they are part of the expense of running the business of renting the unit.

Don’t forget depreciation. This is the big deduction on a rental property. You get to deduct depreciation even if the value of the property is going up. And you have to adjust your basis when you dispose of the property by the amount of the depreciation whether or not you claimed the deduction, so you should do so.

Condo fees would normally be deductible.

You may be able to deduct up to $25,000 in passive activity losses against your other income if your modified AGI is under $150,000 ($75,000 if married filing separately). (Phaseout begins at $100,000.)

But let’s say your AGI is greater than $150,000 so you will not be able to deduct any of your passive activity losses. You carry them forward to the next year. Your losses do not affect your capital gain on the sale of the property, but you can use your losses (including unused accumulated carryovers) as a deduction from your other income in the year you sell or otherwise dispose of the condo.

See Publication 925.

More subtle than that even…“business” and “rental” are different in the way they are treated.

One key dif that I’m not sure was mentioned above…$25,000 of rental losses, although a passive activity, can be deducted if your other income isn’t higher than a specific amount.

Originally (and this goes back quite a few decades) houses, even residential, were counted as investments and mortgage interest was treated as an investment expense. Then exemptions came in, first for people over 65 and then, I believe (it has been a long time since I lived in the US) for everybody. After my father died at age 63 I filled out his income tax and should have declared the “profit” over many years of inflation. I said, to hell with that, since the feds had no way of tracking property sales in those days before the i-net. Had he lived another 23 months, there would have been no liability.

But when deductibility of carrying charges was ended, there was a general feeling of supporting home ownership. So it was decided to continue the practice by which lower classes renters would subsidize middle and upper class home owners. This subsidy continues since the money you invest in owning your house pays your rent and is untaxed income, while renters pay with after-tax dollars. This point was driven home when a friend of mine arranged a sabbatical home exchange with someone from another state. Many years later, someone told him that he and the other guy should have declared and paid taxes on the fair rental value of their homes, while the rent they theoretically paid was not deductible. In Switzerland–at least in the canton of Zurich, the fair rental value of your home is added to your income and taxed–quite properly.

At the most basic level, I’m understanding that:

Interest on the primary residence is deductible against your normal/general income.

Passive investments/rental RE can only generate deductions against their own income; money which that investment makes. You can’t use them to create losses to deduct from your normal (employment?) income. Thus the idea that “you can’t use the government to help pay for your entertainment”.

See above. You can deduct losses up to $25,000 per year from rental properties against other ordinary income even if you are not a real estate professional if your adjusted gross income is below a certain amount. Also note that the amount you charge for rent on the property must be reasonable, i.e. you cannot charge $400/month in rent to a buddy and generate rental losses that you are deducting on your taxes if the average rental prices for a similar property in the area are $1200/month.