Consolidating loans on investment property with primary residence mortgage

[hindsight2019]

I have three mortgage loans : 2 on investment properties and one on primary residence. They are about 333k each. I can refinance primary residence with cash out to total of 1m loan and pay off investment property loans. My net cash out is 0. Reason: investment property rates are higher by at least 1 percent. Question: can I continue to deduct the interest reported on 1098 for primary residence on schedule E as usual? (Upto 333k each)

[Anonymous]

can I continue to deduct the interest reported on 1098 for primary residence on schedule E as usual? (Upto 333k each)

this makes no sense since interest on primary residence is reported on schedule A.

however.  if you refied your primary for $1 million, IRS tracing rules would still require that amounts used to pay off loans on investment property, still be attribute that property and deducted on schedule E. 

[hindsight2019]

I will restate. I refinanced my primary mortgage. $1m is reported on 1098. I had used $333k x 2 to pay off investment loans, abd $333 loan on primary home. 

Does my tax return look the same before and after refinance? 

[NCperson]

@Anonymous - so are you saying the strategy works or doesn't work? Wouldn't the resulting $1 million loan have to be collateralized by all three properties for the strategy to work. (the bank shouldn't have a problem taking more collateral against their loan),

I just don't see that example or discussion in the IRS publication that supports @hindsight2019 situation.  

https://www.irs.gov/pub/irs-pdf/p936.pdfrts

How could you deduct the interest on Schedule E if the loan is only collateralized by your primary residence? 

[hindsight2019]

Note: $1m loan is secured only by my primary residence (hence the lower interest rate)

[NCperson]

I understand the proposed loan would only be collateralized by the your primary residence.  Read the link i posted as I wonder why the IRS wouldn't look at this transaction as a 'cash out' where the money is not used for capital improvements on that same primary residence, and therefore all the interest would not be deductible

[hindsight2019]

Yes, that is the normal course. But if the funds are used to lower interest on investment property and pay off that loan, there is apparently a traceability provision. I am looking for applicability of that to this situation so I can deduct the loan on my schedule E legally.

[Carl]

No, you can't claim one single penny of mortgage interest on SCH E because the rental property is not used in any way, form or fashion to secure the loan. You're also not investing any of the loan money back into the rental property since there is no "cash out" money to do that with. The new loan is secured only by your primary residence. Therefore all of the interest can only be claimed on the SCH A. Furthermore, due to SALT limits (State and Local Taxes) as well as mortgage interest limits, you're limited to deducting the interest on "only" the first $1M of the outstanding balance on the new loan, and a maximum of $10K for your SALT deductions.

What you may "save" in interest, you will "pay" in taxes a few times over.

Additionally, it doesn't make sense to refi any loan if the interest rate isn't "at least" 2% lower. If the new loan results in a "savings" of 1% on the interest rate, you'll never recover or even break even with the refi and closing costs you'll pay. Think this through long term. Short term savings now will cost you dearly later.

[NCperson]

<<you're limited to deducting the interest on "only" the first $1M of the outstanding balance>>

@Carl - I'd argue that he can't deduct the interest related to the entire $1mm loan against the primary residence, as "cash out" interest can only be deducted if the principle was reinvested to improve that primary residence. And the idea would use the 'cash out' to pay off another loan unrelated to the primary residence and not to improve that primary residence.  If the loan was collateralized against all three properties, I think it could work (but creates problems if you later want to sell one of the properties and not all three at once - you may have to refi again)

@hindsight2019 further, I'd suggest obtaining documentation of any "traceability provision" from an IRS source before executing on the strategy; the publication link I provided doesn't take about that, 

[hindsight2019]

The 1% proposed savings on my loan are net savings (with zero closing costs), hence in my interest in the strategy.

if I buy a rental property from the cashout of the primary residence, that interest is deductible as investment interest even though the rental property is not a collateral in the Cash out Refi. Right? 

[Critter]

Tracing rules come into play in this situation if you make the election and keep good records :  See page 4 : https://www.irs.gov/pub/irs-pdf/p525.pdf

Choice to treat the debt as not secured by your home.

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.

Read these articles :  

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

https://www.dmj.com/dmj-blog/deductibility-interest-tracing-rules/
https://www.taxcpe.com/blogs/news/tracing-rules-that-apply-for-deductibility-of-interest

[Carl]

I'd argue that he can't deduct the interest related to the entire $1mm loan against the primary residence, as "cash out" interest can only be deducted if the principle was reinvested to improve that primary residence

Actually, there is no argument on that, because you're right. He can only claim/deduct that portion of the interest that applies to whatever the outstanding balance on the original loan was, prior to the refi. The fact they used the "cash out" to pay off the rentals is completely irrelevant and just doesn't play into this since the rentals are not collateralize against the refi $1M loan at all.

So while interest percentage-wise it saves 1 lousy percent on the interest, it actually reduces the dollar amount of total interest paid overall. The downside is that the amount of "deductible" interest is significantly reduced, but so what? Depending on the rent being charged, the amount of rental income money he actually gets to keep instead of sending it to the mortgage company in the form of non-deductible principle will be as much as 40% more or less, depending on how far he was into the mortgages on the rentals prior to paying them off.

So while the tax liability overall may not change much, he gets to actually keep in his pocket more of the money that he would pay taxes on anyway, without the refi. So after that train of thought, I'd do the refi and just accept the fact that 30% (more or less) of my interest on the refi loan would not be deductible.

[Critter]

But due  to the tracing rules he can deduct the rental portion of the refi on the Sch E ... so he used to have mortgages on 2 rentals(reported on the Sch E)  and one personal home (reported on the Sch A)   ... after the refi he will still have the same situation ... the consolidated loan can be divided 3 ways if the taxpayer wants to use the tracing rules ... so the net effect of the refi is he will pay less interest overall and 1% reduction on a million dollar loan is some serious scratch.  I would do it if you can. 

[Rick19744]

I agree that the tracing rules can be used here.  

• Be careful of the refinancing rules related to your qualified residence
• Take a look at Chief Counsel Advice 201201017 (CCA 201201017).  I believe this supports the ability to do this.  However, keep in mind that the CCA is applicable only to the taxpayer (IRS agent technically) in the advice memo, but provides an indication of the IRS position on this matter.
• Pub 936 has changed since the CCA was issued, but the rules are discussed on pages 13 and 14 of the 2018 publication.
• Just to provide some clarification on bullet #2, when an IRS exam is going on and either the agent or their supervisor have a question on a particular legal matter of the case, they refer the question to the appropriate Chief Counsel office for advice.  Chief Counsel Advice (CCA) are legal advisories written by the Chief Counsel's National Office to advise IRS personnel at all stages of case development. So technically, the advice is provided to the IRS field office, but related to a particular taxpayer and their specific facts.

[hindsight2019]

@Anonymous a friend of mind asked his CPA and got the following response. But before that I will restate the current situation.

property A: primary residence. loan amt $300k

property B: rental prop. Loan amt $302k

property C: rental prop. Loan amt $298k

proposed situation: 

property A: refinance for $900k secured by principal residence only. (The new loan is at much lower interest rate  even after zero closing costs.) Use “cashout” portion $600k to pay off the loans for rental property B and rental property C.

question: is the proportional interest of $600k deductible on the schedule E. 

CPA opinion: yes, *so long as* loans for property B and property C are paid off directly from Refi escrow of property A. That will establish tracing requirement. 

I have not talked to this professional directly. 

Do you folks concur?