I noticed nobody has replied to your question. You are correct that the $29,000 is not included when determining the mortgage interest. If you did the refi this year you will have two 1098s. Specify the the 1st 1098 as a refinanced mortgage. Specify the 2nd 1098 as a refinance of a previous loan. When asked for the amount used to buy or improve your home, enter the balance of the refinanced mortgage before refinancing plus the $40,000 spent on improvements. This enables Turbo Tax to figure the mortgage limitation correctly.
You will continue to specify the current mortgage as a cash-out refinance going forward. This enables Turbo Tax to apply principal payments to the $29,000 non-acquisition balance first.
