Interest deduction on cash out refi from rental

So…I think I screwed up. Recently did a cash out refi on a rental in anticipation of the RE and/or stock market softening in 6–18 months. Took out a few 100k and had planned to deduct the interest on Schedule E. Now, after doing a bit more reading, I’ve learned that only the interest on acquisition debt is deductible.

Anyone have experience with this or suggestions? For those that routinely take cash out of rentals, where do you put the proceeds for maximum tax efficiency?

There are no limitations on the amount of interest you can write off against rental property income. If you take out a $2,000,000 mortgage against a rental property that includes $1,300,000 in traditional mortgage debt and a $700,000 cash-out portion, you can claim every penny. Furthermore, you usually can claim losses on one property to offset gains on another property. If you lose money on all of your properties because of mortgage interest or other expenses, you may be able to use that overall loss to offset other income. Finally, mortgage interest reduces the income that goes into your AGI. Having a lower AGI can, among other things, keep you from paying the deduction-robbing Alternative Minimum Tax.

Buy another rental.

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That’s what I thought, but more accurate articles reveal it’s not true:

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If you use the cash out money to buy rentals then all is deductible, right? What matters is whether the money is used for investment purpose?

Yes, but it is deductible as an expense for the rental that you bought, not the one you refinanced. Very confusing to do it right…need to keep good records to trace where it went.

If you buy stocks or bonds you can deduct it as investment interest, but the investments can’t be tax exempt (i.e. munis).

It doesn’t really matter which rental takes the interests deduction. You can bank the extra deduction indefinitely for future use. You don’t lose it.

I have actually been doing it that way… took a 1st position cashout loan on a free-and-clear property, bought another rental, tax return shows it as a 2nd loan on the new rental. I was thinking I would make a mistake, now I see, I actually followed their guideline.

I did not know that either…

How does a violation of this get proven? i.e. I have $100k cash, then do a cash-out refi and obtain another $100k, now $200k cash available, then I buy a tax exempt investment for 50k…? The linked article gives no insight. Separate accounts required?

This is where the tax law gets really complicated…there are different levels of conservatism. I believe the wording is that to be deductible as investment interest the proceeds can not be used to “carry” tax exempt securities. It could be argued that the cash-out refi has enabled you to purchase the tax exempt investment because it replenishes the $50k you spend, especially if you do it around the time of the refi. Some people are uncomfortable owning any tax exempt securities at all when deducting investment interest. Others feel it is sufficient to show that the proceeds were not directly used to purchase a tax exempt investment.

This tracing rule is not complete. Say you refi $300k, use $50k to purchase a car for personal use. One week later, you top up the $50k. Does it mean only 1 week worth of mortgage interest is not claimable for the $50k? Or top up is not allowed, you end up on hook to claim mortgage interest for $250k for the remaining life of the mortgage?

On further thought, I realize the issue arises only if you wants to deduct interest from rental income, even though you are using the cash out for personal uses. Is kind of trying to exploit a loophole that was closed in 1987.

This gets complicated and I’m by no means a CPA, but I suspect to “top off” the cash from the refi and legally deduct the full amount you’d have to sell the truck you just bought. If you top off with funds from another source the tracing would show they didn’t come from the refi for which you’re trying to deduct interest.

Of course the odds of an audit are ~1%. I suspect many/a majority would just deduct interest on the full $300k and get away with it.

Is it a problem if you use your salary to pay off rental property mortgage?

I assume that you can use rental income for personal consumption and use the cashout to pay for rental expenses? It would be absurd if they don’t allow people to use rental income to support themselves. However, if it’s in the same account, how do you know people use the cashout or rental income?

Allow me to repeat myself🤬

I did some reading.

So whenever you change allocation, you need to record it. That is even if initially you spend the full loan to buy a rental, when you sold the rental before the loan is repaid, constitutes a change in allocation. If you use the proceeds on a Primary, the mortgage interest would cease to be claimable.

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In conclusion, cash-out refi is for old unemployed folks who don’t have passive income but need $ for daily life, instead of piling up credit card debts, can cash-out refi the house if they have one. Cheaper than credit card debt.

I don’t think this is true… There are plenty of ways to use it to your advantage…just have to trace the proceeds carefully/follow the rules.

If you have enough assets you can completely work around the $750k cap on the mortgage interest deduction: Manch can buy his $4M house in Hillsborough with $3.25M cash and a $750k loan, then refi to a $3M loan at 2.5% and invest the proceeds in the NASDAQ/S&P500. All of the interest is now deductible (750k as mortgage interest and 2.25M as investment interest).

Not that free. Have to do that till loan is repaid.

I ain’t gonna buy anything in Hillsborough. Don’t like that Yan Can’t Cook guy. :angry: