How do I report negative-amortization on a rental house?

[azbesthomes]

I stumped the IRS helpline with this one... perhaps you have an answer:  I owned several rental homes from 2006-2009, and all of them had those option ARM, neg-am loans on them.  I.e. - the monthly interest charge would be, say, $1000, but my payment due was only $600.  The balance of the interest, $400, was added to the principal of the loan.  Two questions: in each year, am I able to deduct the full amount ($12,000) as interest, or just the 'paid' portion ($7200)?  If the deduction is $7200, do I show the $4800 "deferred interest" as capitalized somehow (increasing my cost basis)?  And lastly, upon disposal of the property, are there additional considerations?  Thank you for your time!

[Douglas Rutherford, CPA]

As an individual, you need to view this situation on a "cash" basis...  you generally can't deduct mortgage interest until you pay it..  and in the case of a negative amortization loan, the deductible amount is what is actually "paid" which is less than what is "accrued." 

If you make additional principal payments, then you may be able to deduct additional interest payments.

When you sell the property and pay off the full loan amount (which would include the accrued interest), you can then deduct the “extra” interest expense.

Hope that helps,
Doug

[azbesthomes]

It does help... thank you!  Taking that scenario one step further... the property goes into foreclosure and is sold for way less than the amount owed -- i.e. $200K owed, credit bid at auction is $100K and no other bids, and of the $200K owed, lets say $20K is deferred interest.  When reporting the asset disposal at $100K on the tax return, would the $20K deferred interest be counted as paid "interest" (since interest is paid before principal) or a capitalized expense or sale expense?  Again thank you for your service!

[Douglas Rutherford, CPA]

Ok, now you are introducing a whole new set of facts.

The most probable reporting is that the interest expense will be treated as paid...  but you will have debt forgiveness income for the same amount since you would not have paid it …  of course, that would offset the expense...

I recommend that you meet with a local CPA to discuss the specifics of your deal to go over ALL the facts and so that you can avoid loosing out on any planning opportunities that may be available before the transactions closes... 

Little planning can be done after the fact... 

Good luck.
Doug