There are occasions when individuals are advised to borrow money against property (non-residence) or securities they own in order to fund the purchase of, say, a home or a vehicle. Then, they are often incorrectly told that the interest is deductible as either mortgage interest or investment interest.
Interest on a loan not secured by the first or second home, as is the case above, must be traced. Traced interest means categorized based on the use of the loan proceeds. These categories include trade/business, passive activity, investment, portfolio and personal.
For example, Joe takes out an equity loan against his rental property, so that he can purchase a new car for personal use. Mortgage company issues a Form 1098, reporting the interest paid. However, since he used the proceeds for personal use, the interest expense is not deductible against the rental income. In fact, the interest is not deductible at all because it is considered personal interest. Alternatively, if Joe had taken out an equity loan against his principal residence and purchased a car, the interest would have been deductible as mortgage interest. (This is assuming the balance of his equity loan against his residence is less than $100,000 and he is not subject to the alternative minimum tax.)
In an actual tax court case, Ellington, T.C Memo 2011-193, the taxpayers purchased a personal residence and secured the loan, used to make the purchase, partially against the residence and partially against securities owned. The taxpayers deducted the interest on the portion of the loan secured by the securities as investment interest expense. The Court disallowed that deduction, stating that the interest on the loan not secured by the residence must be categorized based on the use of the loan proceeds, not the assets securing the loan. Since that portion of the loan was not secured by the residence, the interest on that portion was considered personal and not deductible.