You can deduct interest on your main home and one second home, BUT a deductible mortgage must be secured by the property. A mortgage secured by house #1 would only count as a mortgage on house #1, no matter what you used it for, and the cash out would be considered non-deductible equity interest rather than qualified interest for home #2.
I would be very surprised if you could do a cash out refinance of house #1 for a lower interest rate than a primary mortgage on house #2, in any market. They would normally be the same rate, if they are Fannie/Freddie conforming loans.
Note that your effective interest rate on a deductible loan is 20% less than face value, if you itemize your deductions. In other words, 5% with the itemized deduction is equal to 4% without the itemized deduction.
If you don't have the full 20% down for house #2 to get the best interest rate, you might get an 80% mortgage on house #2 and a cash out equity line of credit on house #1 to make up the difference, that way most of your debt would be qualified for the deduction.
This market also might be a good time for an adjustable rate mortgage, if you think inflation and interest rates will settle down again in a couple of years.
