Cash-out refinance on rental

[hindsight2019]

Question on investment property. Current loan: 300k. Property value: 2M. My depreciation+mortgage interest+ expenses are lower than rental income. Which means I am paying taxes. Also I can reduce my interest rate, but only if I go to 1M interest only loan. That will increase my mortgage expense. I can use the money to pay off of mortgage on my principal residence. Question: is the entire interest on my investment property deductible on schedule E (subject to passive income); or am I capped by 350k current loan? Thank you. 

[soultax09]

this is from pub 527......When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense.

[hindsight2019]

Thanks. Appreciate it. Is there a specific section I should look up in 527. Unfortunately the only way I get better interest is by going for higher mortgage. One possibility of course is I can pay up the principal right after refinance to bring down the mortgage to the previous amount. A gimmick I may have to play. 

[Carl]

One possibility of course is I can pay up the principal right after refinance to bring down the mortgage to the previous amount. A gimmick I may have to play.

Not sure what your train of thought is on that, but it's wrong. If you owe $250K on the current loan and you refi for $1M to cash out $750K, and you don't invest any of that $750K back into the rental property, that means you can only claim 25% of the interest you pay on the loan on the SCH E, for the entire life of the loan. Paying it down to "what you owe" won't make any difference.

At best, the remaining 75% of the interest paid would be an itemized deduction on SCH A subject to the SALT limitations.

[hindsight2019]

My drivers were two fold (1) reduce interest rate from the current one. Unfortunately that is possible only if I get jumbo loan at 1M based on what my mortgage broker told me. (2) consolidate other loans. 

Based on the information provided by you in this forum, (2) above won’t work, as the interest beyond my original loan won’t be qualified interest for deduction. 

So I am thinking I will get 1M loan to get better interest rate, and payoff 700k right away. (No prepayment penalty). This way I am still within the original 300k loan. That should be fully deductible on my schedule E. Do you see any issues with this approach?

Thank you.  

[Anonymous]

there will be loan costs. these costs have to be amortized over the life of the mortgage.   how many years will it take to recover these costs through lower interest. 

also if you can prepay immediately without penalty it seems strange that  they won't offer a $300,000 loan.    try  another mortgage broker.  

[hindsight2019]

Thanks, yes Good point on the closing costs. I will need to run numbers on when those reach break even point.

What if I use the “extra” 700k to buy another rental property? Is the interest deductible against income for that property? 

thanks.

[Critter]

Using the refi for another rental is a valid use and is deductible on the new rental. 

[hindsight2019]

Oh really? I thought for the loan to be deductible on a property, the property itself should have been used as a collateral. Does that rule not apply to investment properties? Thanks. 

[Critter]

They are called Tracing Regulations ... in short if you take a mortgage on your personal residence but use it to buy a rental then the interest is deducted on the Sch E  and not the Sch A.

 https://cdn.ymaws.com/www.oatc-oregon.org/resource/collection/E359D405-F529-4348-B521-421CFD25FA2B/H...

[hindsight2019]

Ah! That makes sense. Thanks for the link. So taking loan from one rental property and applying excess beyond the original loan to second  rental property will just follow the second property in schedule E? Will read the link.

[hindsight2019]

Wow! So if I cash out money from my rental property and invest in stocks, can I use interest to offset my gains in schedule D? @Critter 

[Critter]

NO ... investment interest does not go on a Sch D ... margin interest never has. 

Nice thought but it goes on form 4952 which then goes to the Sch A  and  such interest is only deductible up to the amount of taxable investment income reported (and, in this case, investment income does not include any capital gains or qualifying dividends that enjoy favorable tax treatment).

[hindsight2019]

Thank you @Critter . I have never taken high margin interest, so I wouldn’t know where to put it (schedule A, as you explained).

Let me ask you this. If my motives for getting cash-out are to reduce interest rate, *AND* have liquidity for emergency, can I apply mortgage interest in excess funds, to offset gains on interest income from CD’s (schedule B)? They don’t have favorable tax treatment unlike stocks and dividends. 

Appreciate your insights. 🙏🏽

[Critter]

And again that is a NO.   I highly suggest you sit down with a local professional financial planner who has income tax knowledge to get better educated in these matters ... to avoid a few $$ of taxes you may wind up paying much more in mortgage interest ... and most people would not condon using borrowed money to make money in many instances.