Tracing rules cover interest used for different purposes; however, residential mortgage debt is carved out of the reg and covered differently:
2) Treas. Reg. §1.163-8T(a): (6) Special rules—(i) Qualified residence debt. [Reserved] - the rules are not part of the reg but part part of Publication 936
If you look at Publication 936, there are two sets of rules that must be met for the interest to be deductible
"Part I:
Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, or a second mortgage. You can deduct home mortgage interest if all the following conditions are met.
- You file Form 1040 and itemize deductions on Schedule A (Form 1040).
- The mortgage is a secured debt on a qualified home in which you have an ownership interest. (Secured Debt and Qualified Home are explained elsewhere in the publication)
Note. Interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan. As under prior law, the loan must be secured by the taxpayer’s main home or second home (qualified residence), not exceed the cost of the home, and meet other requirements."
Note that your approach will fail the test in red font and most critically the bolded part of the red font.
Part II
This part of the publication discusses the limits on deductible home mortgage interest. These limits apply to your home mortgage interest expense if you have a home mortgage that doesn't fit into any of the three categories listed at the beginning of Part I under Fully deductible interest, earlier. Your home mortgage interest deduction is limited to the interest on the part of your home mortgage debt that isn't more than your qualified loan limit.
I am not going to write out the rest of Part II but it pertains to the new $750,000 loan limit, the prior $1,000,000 loan limit and grandfathered mortgaged.
