Acquisition Debt vs Home Equity Debt & Cash Out Refinancing

You are looking at the final purpose of the money to determine whether it is held for investment, personal, or business reasons. I'm not sure the law does this. The form 4952 has the instructions on it and says

BEGIN QUOTE form 4952

Property held for investment. Property held for investment includes property that produces income, not derived in the ordinary course of a trade or business, from interest, dividends, annuities, or royalties. It also includes property that produces gain or loss, not derived in the ordinary course of a trade or business, from the disposition of property that produces these types of income or is held for investment. However, it does not include an interest in a passive activity.

END QUOTE

So the 150k sitting in a bank account is investment property. Does the IRS care about the final use of this property? If yes, then any investment is personal use, because your investments today will be used later (even years from now) to buy a bigger house, buy bigger cars, fancy travel, gifts for kids and grandkids, etc.

Suppose you do win the argument that the 150k had a purpose in the near-future of buying a vacation home, which is personal use, thus disqualifying the interest paid on this amount as investment use. Now suppose the person was very rich, having over 500k lying around. So they buy the vacation home using this other money and leave the 150k in the bank account earning interest or buying stocks with it, while writing off the interest on the 150k as investment interest. So suddenly because they have multiple sources of income, it becomes impossible to trace where the 300k to buy the vacation home came from, and the rich person gets benefits not afforded to a poorer person. This doesn't seem fair and seems to violate the 14th amendment.

The original post didn't say what else the person had, but if he had

1099-INT income, 1099-DIV income from other sources, that would make the investment interest deductible to the amount of 1099-INT and 1099- DIV income.

My concern is that the parking of the money in the interest-bearing account was only a temporary event. Note that in another reply, I did NOT say that there wouldn't be any interest expense deduction but actually implied that there may be. I look at the reason that the debt was incurred in the first place, and that reason was to purchase real estate. If the reason for incurring the debt were to invest, then I'd be more willing to call it investment interest.

I did find IRS Guidance that supports D. Stussy's position. It is buried in IRS Notice 88-74.

TREATMENT OF DEBT WHICH IS PARTIALLY ACQUISITION INDEBTEDNESS AND PARTIALLY HOME EQUITY INDEBTEDNESS Regulations will provide that a single debt may qualify as partially acquisition and partially home equity indebtedness. Therefore, for example, if a taxpayer incurs a debt secured by his qualified residence and uses a portion of the debt proceeds to refinance an existing acquisition indebtedness and uses the remaining portion of the debt proceeds for purposes other than the substantial improvement of the residence, the portion of the debt used to refinance the acquisition indebtedness will qualify as acquisition indebtedness and the portion of the debt used for other purposes will generally qualify as home equity indebtedness, subject to the $100,000 limitation on home equity indebtedness.

See Reg. 1.163-8T(c)(4). This is where you have to use the tracing rules for determining what type of interest expense you have.

=====================================================================(4) Allocation of debt; proceeds deposited in borrower's account?(i) Treatment of deposit. For purposes of this section, a deposit of debt proceeds in an account is treated as an investment expenditure, and amounts held in an account (whether or not interest bearing) are treated as property held for investment. Debt allocated to an account under this paragraph (c)(4)(i) must be reallocated as required by paragraph (j) of this section whenever debt proceeds held in the account are used for another expenditure. This paragraph (c)(4) provides rules for determining when debt proceeds are expended from the account. ===================================================================== Until you do something else with the proceeds, the bank deposit is considered investment property and any interest expense you incur is investment interest expense. It doesn't matter what your original intent was for use of the debt proceeds. It remains investment property as long as the funds remain in the account.

Right, but if you take that at face value, you've also reclassifed the equity part of the debt as investment interest, meaning that the interest on the equity debt portion is not deductible if there's no portfolio income to offset it. I don't think we want to go that far, thus leaving only the $50k which is not acquisition debt and exceeds the equity debt limit (of $100k) as subject to the investment interest rules as interest on equity debt is otherwise deductible regardless of how it's used.

I'm not in disagreement. I am merely saying bank accounts are investment property and interest you pay on the debt that created the bank account will count as investment interest expense unless you have the option to treat it as something else and you elect to treat it as something else. E.g., the cash from a refi can be deposited into a bank account and if you have not already reached your $100K limit of home equity debt, you can treat up to $100K of the bank deposit as HE debt and the balance would be investment property debt.

Suppose there was just 100k of debt instead of 150k. Can you elect to deduct the debt as either HELOC debt or investment interest? HELOC interest is great because you can deduct interest on the full 100k, but if you're in AMT and/or have lots of investment interest (1099- INT, non-qualified 1099-DIV, short term capital gains) then investment interest is better.

Good question for which I am not sure. However, IRC 163(d)(3)(B) says that investment interest does not include qualified residence interest as defined in 163(h)(3). That section includes both acquisition and home equity debt as qualified residence interest. I most conclude that if you have a secured loan that meets the definition of HE debt, then depositing the funds in the bank does not change its character. It is HE debt. I do know, that if you withdraw some funds and spend it on capital improvements for the property that secures the loan, that amount gets converted to acquisition debt. I must assume therefore, that if you withdraw some of the money and spend it to fit up your business, you have converted that portion to business interest. Any amount that still remains in the account would continue to be HE debt and not investment debt.

For one day, then he refis the 200K loan @ 3.9%.

Seth