I paid closing costs for a refinance of my rental property. How do I navigate to the correct location to enter the closing costs?

[DawnC]

You have to figure the average balance of each mortgage to determine your qualified loan limit. You need these amounts to complete lines 1, 2, 7, and 12 of Table 1. You can use the highest mortgage balances during the year, but you may benefit most by using the average balances. The following are methods you can use to figure your average mortgage balances.   Link is to Pub 936 

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The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities.  If you use the proceeds of a loan for more than one type of expense, you must allocate the interest based on the use of the loan's proceeds.

Allocate your interest expense to the following categories.

• Nonpassive trade or business activity interest.
• Passive trade or business activity interest.
• Investment interest.
• Portfolio interest.
• Personal interest.

In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.   Pub 535

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You can choose to treat any debt secured by your qualified home as not secured by the home. This treatment begins with the tax year for which you make the choice and continues for all later tax years. You can revoke your choice only with the consent of the IRS.

You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest.  Pub 936

[Mac1287]

Thank you for the detailed response @DawnC . I did read through this section before and is part of the basis why I believe the percentage of the deductible mortgage interest varies (specifically, it decreases over time as long as there are no further modifications to the existing mortgage and no new mortgages are introduced). 

In particular, the section titled Mixed-Use Mortgages with the below excerpt, along with Example 1 seem to confirm this:

1. Figure the balance of that category of debt for each month. This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order.

   1. First, any home equity debt not used to buy, build, or substantially improve the home.

   2. Next, any grandfathered debt.

   3. Finally, any home acquisition debt.

Example 1 suggests that the Home Acquisition Debt ($180,000) doesn't decrease over the course of the year, but the Total Debt ($200,000 -> $190,000) and Home Equity Debt ($20,000 -> $10,000) do. And to extrapolate from the example, the deductible mortgage interest at the start of the 2nd mortgage is at 90% (180,000/200,000) in March, while at the end of the year it is at 94.7% (180,000/190,000). And obviously the ultimate number used for the year would be the average.

However, I believe this contradicts what @Carl said in an earlier response:

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But this gets complicated, to determine  year after year what qualifies as 'improving the property', since the new loan is for a long 20 or some years.  But I understand what you are saying. 

Be aware that percentage remains the same each year, for the life of the loan. But also be aware that it "can" change too. As an example, use my numbers above. With those numbers, only 80% of the interest on the new loan are deductible every year, for the life of the loan.

But let's say 2 years from now in 2024 I install a new Central Air unit in the property at a cost of $5000. Provided I've got the documentation to prove it (the tracing rules to show I used "that" cash out money for this) then that means I can, starting in 2024, claim 90% of my mortgage interest on the loan.

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I just want to clarify that the percentage of deductible mortgage interest varies over time and eventually increases to 100%, specifically with mixed-use mortgages (such as a cash-out refi), and that it is not calculated only once at the beginning and applied yearly until the loan is fully paid off.