Should I get a loan on my home and pay cash for an investment property, or just get a loan on the property itself?

Should I get a loan on my home and pay cash for an investment property, or just get a loan on the property itself?

by Michael A. Gillen, CPA | Oct 31, 2017
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I am interested in purchasing an investment property. Is it better to get a loan on my primary residence and pay cash for the investment property? Or is it better to just get a loan on the investment property itself?

From a pure mortgage perspective, the mortgage that provides the lowest costs and most favorable terms is usually preferred. 

From an economic perspective, while paying cash avoids the need to pay interest on the loan, points (mortgage origination fees), appraisal fees, mortgage recording fees, and other fees typically charged by a mortgage lender might not be financially prudent. If, for example, your after-tax rate of return from investing the cash is greater than the after-tax interest rate of the mortgage, paying cash is not prudent. Mortgage rates are presently low, and investment yields have been favorable. The combination of lower mortgage rates, tax deductibility of the mortgage interest, and higher rates of return on the cash invested could suggest some leverage. 

From a tax perspective, whether you obtain a mortgage against your primary residence or take out a separate loan to buy an investment property, Section 163 of the Internal Revenue Code should allow a deduction for interest paid on a loan. The rules are tricky for second residences and rental properties, however. For example, a taxpayer can deduct interest on up to $1 million in acquisition debt on their primary and secondary dwellings. A taxpayer can also deduct interest paid on up to $100,000 in home equity debt. So, if the amount of the home equity loan to acquire the investment property is $100,000 or less, the interest should be deductible. If the loan is greater than $100,000, Treasury regulations provide “tracing rules” that allocate debt and interest depending on the type of expenditure to which the proceeds are applied. Essentially, the tracing rules automatically allocate debt depending on how the proceeds are used. 

If you choose to get a loan on the investment property itself, and the loan is secured by the investment property and the investment property is not rented, the interest is deductible based on the limits noted above. If you choose to get a loan on the investment property itself and the loan is secured by the investment property and the investment property is rented (and not used personally), the interest will be considered acquisition debt and deductible from your rental income. If the investment property is used personally and rented, the interest must be allocated based on special rules. See IRS Publications 936 and 527 for details.

At the end of the day, the answers depend on your personal situation.

For more resources, check out PICPA’s Money & Life Tips, Ask a CPA, or CPA Locator.

Answered by: Michael A. Gillen, CPA, is director of the tax accounting department at Duane Morris LLP in Philadelphia.
Disclaimer
The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.
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