Avoiding Business Refinancing Traps

Are you one of those few lucky people who owns an investment property that was appreciated over the years?  Are you considering cash-out through refinance to take advantage of this historically low mortgage rate? By refinancing your current mortgage, you may get a significant amount of cash in your hands. Since you don’t have to recognize any gain at the moment, you don’t have to worry about taxes just yet. After all, it’s another loan, not a sale. To make things sweeter, you will probably assume that the interest expenses are deductible, so that it will reduce tax on your property income in future. So far, it sounds like a great plan.If you own the property through LLC or S-corp, however, you may want to pay special attention to the deductibility of interest expenses. To give you better understanding, let me use a quick example.

About five years ago, you established the Strip Mall, LLC with your brother to buy a local strip mall. The LLC purchased the mall at $1 million dollars with a mortgage of $800,000. The mall was appreciated significantly over the last three years, and its fair market value is now $3 million dollars. You and your brother decided to refinance the mortage based on the current value of the mall. After paying off the existing loan, you got distributed half million dollars each. Your invested the half million to buy another investment property, but your brother used the money to purchase his first home. Can the Strip Mall LLC write off the expenses of the entire interest cost?

The Internal Revenue Service defines the deductibility of interest expenses mostly based on the use of the money, not based on the underlying security.[1]This is often called the “tracing rule.” However, most taxpayers are not familiar with this rule. Instead, taxpayers tend to assume that the interest is always deductible based on character of secured assets,  just like their deductible home mortgage interest expenses. Yet, the way that interest expenses are handled are quite different from this assumption.

Referring back to our example, say you purchased another investment property. The interest expense allocable to the half million that you used for the property has to be accounted for in the books of this new investment property. Even if it is accounted for a new investment, it will be likely deductible expenses.

How about your brother, who has now purchased his first home with the half million? Unfortunately, he will neither be eligible for business interest deduction nor home mortgage interest deduction. His debt is not secured by his residence, [2]  therefore, he is not eligible for the qualified residence interest deduction. His use of the loan proceeds is for his personal home, so the interest is not deductible for business or investment purposes either.

If you are planning to include a financing option to your business deal, it is always a good idea to ask your tax advisor whether you can deduct the interest as an expense. If so, ask when and how.