@TaxComm101 - I agree with what @Carl wrote.
once Home #1 is rented, ALL the interest is deductible on Schedule E. Nothing is deductible on Schedule A. This is the only way the interest related to the cash out can be deductible.
One small point, technically, assuming Home 1 is a 2nd home (and not rented out), the interest on the 'aquisition debt' (the balance of the loan prior to the cashout) remains deductible interest while the cashout does not qualify as deductible interest. The nuance is that the IRS assumes taht over time the cashout peice of the mortgage amortizes first. So over time, the interest that is not deductible keeps going down while the deductible peice (from the aquisition debt) remains constant until the cash out part of totally amortizes.
