I'm considering doing a cash out refinance to lower my rate and fund a few home improvement projects. some of them are larger and clearly improve home value (back yard landscaping), but some are smaller and wouldn't necessarily add much home equity (add a sink to the laundry room.) I know the 2017 tax reform limited what you could do with the cash out money and still be able to deduct your mortgage interest. I'm trying to figure out 2 things... 1) How strict are they about defining what qualifies under the must improve home equity rule? Do I really have to demonstrate an equity bump for all $ spent? 2) What do I do if the projects end up costing a little less than I took out? (~$1K - $2K) Can I just pay the money back to my principal and call it good?
I'm trying to decide if I want to do this and not screwing up and being unable to deduct my mortgage interest is part of the consideration. Thanks!
Of course you can use the money for anything, the question is whether the interest will be deductible.
A qualified home improvement is something that is:
You don't have to get an appraisal after each thing you do to prove that it increased the appraised value.
I really can't be more specific than that, I don't know of any tax court cases that narrow it down to the fine detail you are talking about. If audited, you have to prove any questioned items to the satisfaction of the examiner, or you can appeal to the Tax Court.
If you end up with non-qualified debt (equity debt) you can treat your payments as being applied to that first. However, if you hold onto the money more than 90 days before doing the work, you're going to have to calculate in the other direction as well.
However, for each month of mortgage payments while waiting to do the kitchen, your interest is only 58% deductible. A month or two here and there is probably not too risky, and most people are not audited. The IRS also allows you to use a first month/last month average method instead of calculating the percent of qualified acquisition debt on a month to month basis. (In other words, if you get the new loan on May 1, at which time it is 50% deductible, and by December 31 you have made all your improvements or paid money back and the loan is now 100% deductible, then you can either figure the percent of deductible interest on a monthly basis, or take the start and end and average them together which would give you 75% deductible for 2020.)
If audited, the examiner is going to want to see how you calculated your qualified acquisition debt and determined the deductible interest, so save your bills, invoices, and proof of what work was done and how you made the calculations and which method you used (analyzed each month or used first/last).