Loan refi tracing rules

Last month individual client with a bunch of multi unit rentals refi'd her personal residence and put the 1Mill cash refi proceeds in a newly opened interest bearing account A.

Every 45 days or so, over the next 9 months all the 1 mill will be transferred to a newly created rental operations account NewRentalAcct from which 40 days later she will pay rental operating expenses and make a partial monthly payment to the bank that did the 1 mill refi. The partial pmt will be based on amounts and time refi money was placed in the new rental account.

From her existing rental bank account, OldRentalAcct, she will take distributions for her personal use.

Q1. Is it ok for her to claim the interest attributable to the refi proceeds moved to NewRentalAcct as rental interest expense?

Q2. If answer to Q1 is Yes, does she even have to wait any number of days after transfer to NewRentalAcct to pay rental expenses out of this account? (ie. is the 30 days lookback/lookforward tracing rule irrelevant when using segregated bank accounts?)

My understanding is that the interest tracing rules are formalistic in a way that can either hurt or help the taxpayer.

From pub 535

https://taxmap.irs.gov/taxmap/pubs/p535-012.htm

What's a "rental operations account" anyway, and how do I get one and what do I have to do to make sure it's respected (by the IRS, I guess) as being whatever it's supposed to be, and doing whatever it's supposed to do? Is this "rental operations account" a bank product, like a HELOC?

What happened to the really old, really basic, somewhat arbitrary rule (that's buried in the long-existing section 163 regs, I think) that says that borrowed money that's just "put into an account" is treated as being put into an *investment*, and the interest on that borrowed money is treated as investment interest, until something else is done with the money, with a couple of exceptions, IIRC?

From the IRS Pub link Doug M gave: "



" If you use the proceeds of a loan for more than one type of expense, you must allocate the interest based on the use of the loan's proceeds."

"In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses."

"The easiest way to trace disbursements to specific uses is to keep the proceeds of a particular loan separate from any other funds."

Looks to me that the IRS does not treat borrowed funds as "fungible" (what's the opposit of fungible?) unless you commingle with other monies. So if the refi proceeds are placed in their own account and only used to pay for rental expenses, the interest on that refi is treated as rental expenses. If the account is interest bearing, might have to allocate some of the interest expense to investment interest expense.

The fact that during the same time period collected rents are used in part to pay draws to the owner doesn't change the above interest treatment.

It looks like you've decided this: "So if the refi proceeds are placed in their own account and only used to pay for rental expenses, the interest on that refi is treated as rental expenses."

But you've also got this, from the IRS-Pub-cited-by-Doug-M:

"Proceeds deposited in borrower's account.
Treat loan proceeds deposited in an account as property held for investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest expense. If you withdraw the proceeds of the loan, you must reallocate the loan based on the use of the funds."

They seem to disagree with each other...

Spell Czech, you're right that IRS considers the interest expense on even refi proceeds kept in a dedicated account intended only for rental working capital, to be investment interest except for the interest on the portion of those funds allocable to actual expenditures. Favorable in a way in that the account doesn't have to be interest bearing to get investment interest expense treatment. Unfavorable in that not uncommon for real estate businesses or any kind of business to borrow money and leave it in an account before they need to spend it on a business expense. But in this instance all the loan proceeds will be paid out directly for rental expenses within a few months.

I'm left wondering if "in a few months" is soon enough to overcome the "investment until it's used" notion. IIRC, there's a thirty-day window, but past the thirty days, doesn't that leave the not-yet-used balance as investment by application of the general rule, until it's actually taken out and applied somewhere else?

Loan proceeds deposited in an account are allocated to "investments". But when the loan proceeds are actually used, the proceeds are reallocated based on the use of the funds.

Repayment of principal is allocated first to personal (nondeductible) interest, second to investment interest, third to rental real estate interest w/ active participation, 4th to former passive activities, then finally to trade or business interest.

To make this more concrete, suppose TP borrows $1,000,000 on 4/1/xx and spends $100,000 for rental expenses per month.

On 4/1/xx, the interest paid is 100% investment interest
On 5/1/xx, the interest paid is 90% investment interest, 10% rental interest
On 6/1/xx, the interest paid is 80% investment, 20% rental interest
... and so on.

If there were any repayments of principal, that would first reduce the investment interest portion. A quick way to figure this would be:

rental interest = total interest × (total proceeds used for rental expenditures ÷ outstanding balance of loan);
Investment interest = total interest - rental interest.

A reasonable approximation might be to use average balances to figure the above amounts.

The thirty-day rule that you're thinking of, Spell Czech, is the rule that loan proceeds are treated as fungible for 30 days before and 30 days after the loan is funded. I.e. if rental expenses were paid from some other account, that much of the loan can be allocated to those expenses.

I think the rule I was thinking of is the *fifteen*-day rule [and not a thirty-day rule] found in Temp Reg § 1.163-8T(c)(4)(iii)(B). But now that I've read it again, I'm quite sure I don't know how it works nor how it relates to the scenario in the OP.

I think one can quickly find the 15-day rule in the -8T temporary regs by searching them for the *misspelled* word "unborowed" in an example in the regs which is just *above* the 15-day rule...

https://www.law.cornell.edu/cfr/text/26/1.163-8T

What is the taxpayer/client trying to accomplish with the manipulation of the debt proceeds, anyway?

[later: unfortunately, the search function won't take you to the searched-for word, just to the section that it's in... ]

"What is the taxpayer/client trying to accomplish with the manipulation of the debt proceeds, anyway?"

Response: get a deduction for the interest allocable to the proceeds used to pay rental expenses. And greatly reduce audit outcome uncertainty.

Very similar to the result allowed for pass thru entities re interest tracing for debt financed distributions.