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December 18, 2023 | read

Who Said You Can’t Deduct HELOC Interest? – Interest Tracing Explained

Thomas Castelli

So you’re finally ready to head to the bank and get a home equity line of credit (HELOC) and put a down payment on a rental property. But you keep hearing that HELOC interest is no longer tax deductible thanks to The Tax Cuts and Jobs Act (TCJA).

Not so fast…

Yes, the IRS does say “You can no longer deduct the interest from a loan secured by your home to the extent the loan proceeds weren’t used to buy, build, or substantially improve your home.”. However, the IRS also says “You can choose to treat any debt secured by your qualified home as not secured by the home

Well, would you look at that… If you make this election, the interest may be tax deductible under the interest tracing rules.

What Are the Interest Tracing Rules?

In a nutshell, the interest tracing rules say that interest is classified based on how the debt proceeds are used. And depending on how you use that debt, the interest may or may not be tax deductible.

Now, let’s take a look at the different types of interest, and whether or not it is tax deductible.

Personal Interest

Personal interest is interest from debt used to purchase personal items. This includes vacations, credit card debt, student loan debt, college tuition, a vehicle, and anything else that is personal in nature.

And unfortunately, personal interest is NOT tax deductible.

For example, if you take out a HELOC and go on a vacation to Turks and Caicos, you will not be able to deduct the interest because it is personal in nature.

Investment Interest

Investment interest comes from debt used to purchase investments such as land, stocks, bonds, and other securities. However, if you use the debt to purchase tax-exempt investments, the interest is not deductible.

This type of interest will only be deductible to the extent you have investment income (investment income less investment expenses). It is also important to note that you can only deduct investment interest if you itemize your deductions.

For example, you take $100k out of your HELOC with a 5% interest rate and provide a hard-money to another investor at 10%. Assuming you don’t have any other investment expenses, the $5,000 in interest from your HELOC will be tax deductible because it is less than your $10,000 in investment income.

Passive Activity Interest

Passive activity interest is interest from debt that’s for business or income-producing activities in which you don’t “materially participate”. If you’re reading this that probably means your rental properties.

For example, you use the proceeds from your HELOC to put a downpayment on a new rental property. The interest is now tax deductible.

Trade or Business Interest

Trade or Business Interest is generally the interest you use within a business you materially participate. Typically, this interest is fully deductible as a business expense.

For example, you use your HELOC to buy materials for a renovation in your fix and flip business. This interest will be fully deductible as a business expense.

Bottom Line

Even though HELOC interest is no longer tax deductible if used for personal purposes, you may still be able to deduct the interest if it qualifies under one of the rules above. Which is great news for all types of real estate investors including, landlords, fix and flippers, and private lenders.

To learn about more real estate tax strategies, subscribe to The Real Estate CPA Podcast. Out now on all major podcast platforms!