The "general rule" is that all interest paid or accrued (as the case may be) is deductible. 26 USC § 163(a). However, for an individual taxpayer, the so-called general rule is subject to a very significant exception: "no deduction shall be allowed ... for personal interest paid or accrued". 26 USC § 163(h)(1). "[P]ersonal interest" means all interest other than interest that falls into certain enumerated categories. 26 USC § 163(h)(2). Thus, for an individual, the true general rule is that no interest is deductible, unless it falls into one of the permissible categories. For the purpose of this thread, there are three permissible individual interest deduction categories that are worthy of discussion: interest "taken into account" when computing net passive income (§ 163(h)(2)(C)); interest allocable to a trade or business (§ 163(h)(2)(A)); and "investment interest" (§ 163(h)(2)(B)). I discuss the possible application of each of these three categories below.
The general rule is that "any rental activity" is a passive activity, subject to certain exceptions. 26 USC § 469(c)(2). This applies regardless of whether the rental activity is a trade or business and regardless of whether the property is held for the production of income. However, in order for the computation of net passive income to take into account interest allocable to the passive rental activity, the interest needs to have been paid (among other things) "for the management, conservation, or maintenance of property held for the production of income" or as an "ordinary and necessary expenses paid or incurred ... in carrying on any trade or business". §§ 212(2), 162(a). If the interest expense passes either of those tests or certain alternative tests, then the interest is "taken into account" when computing net passive income under § 469, which in turn means that the interest is deductible under § 163(h)(2)(C).
As mentioned, the preceding paragraph analyses the case where the rental activity is a passive activity. However, what if the interest is allocable to a rental activity that is not a passive activity? In this case, we need to determine whether the non-passive rental activity is a "trade or business" within the meaning of § 163(h)(2)(A). As a matter of logic, the fact that a rental activity is not a passive activity does not imply that the activity is a "trade or business" within the meaning of § 163(h)(2)(A). Some old Tax Court cases address this issue. "[T]he operation of a single piece of rental property may constitute a trade or business ... or may constitute the holding of property for the production of income ... if the taxpayer's activities are sufficiently passive". Hoopengarner v. Commissioner, 80 TC 538, 543 n 8 (1983). The reason this issue is only addressed in old cases is that, as a practical matter, in order for a rental activity not to be a passive activity, it usually has to be a trade or business. However, this is not a logical consequence of the activity being non-passive. That said, if the non-passive rental activity is indeed a trade or business, then interest expenses properly allocable to that activity are deductible under § 163(h)(2)(A).
For completion, I will also briefly discuss the final case, even though it is probably only of theoretical interest. If a rental activity is not a passive activity and is also not a trade or business, then interest allocable to the activity is deductible under § 163(h)(2)(B) if the property is "held for investment", subject to certain limitations set out in § 163(d).
Everything in the above discussion is subject to certain exceptions that I have not discussed.