How do I calculate the portion of the mortgage interest that is deductible as a business expense from a cash-out refinance of a rental property?

[Mac1287]

I did a cash-out refinance for a rental property in 2021. The cash, which was meant as a down payment for another property that fell through, has just been sitting in the bank. From my understanding, with a cash-out refi, only the mortgage interest paid on the original loan amount (prior to the refi) can be considered as a business expense for that rental property, unless the cash-out amount is used to improve the property securing the loan.

How does one go about calculating this percentage? For simplicity, suppose the remaining original principal loan is 200K. With a refinance in June 2021, the new principal amount is 300K, so there is a 100K cash-out. Would the applicable mortgage interest deduction equate to:
(100K / 300K) * (Mortgage Interest Paid since June 2021)

In addition, will the mortgage interest prior to the refi (before June 2021) be wholly applicable as it was paid on the original 200K loan? So the total would be:
(100K / 300K) * (Mortgage Interest Paid since June 2021)   (Mortgage Interest Paid before June 2021)

Turbotax does not seem to account for this scenario in the interview questions.

Thank you in advance.

[KrisD15]

Yes

If the lender did not issue two 1098 Forms, you will need to allocate the proper amount of interest to the rental. 

The percentage in your example would be correct. 

Yes, the full amount of interest before the re-fi would be allowed since it all relates to the rental. 

If you are able to manually compute the interest, enter that amount on the 1098 input screen. 

[Mac1287]

Thank you for the prompt response, @KrisD15 . Just to clarify, I did receive two 1098 Forms, one from the Original Mortgage Company and another from the Refi Mortgage Company. To keep going with the above example,  would the equation essentially change to the following (Note: I realized I made a mistake in the ratios -- 200K is the original remaining loan amount prior to refi, not 100K):

(200K / 300K) * (Mortgage Interest Paid on 1098 Form from Refi Mortgage Company) + (Mortgage Interest Paid on 1098 Form from Original Mortgage Company)

Thank you again.

[Opus 17]

Only interest on acquisition debt is deductible.  Acquisition debt is debt used to buy, build or substantially improve the property.  Interest on the equity debt is not deductible.

If we assume the original loan through June 2021 was all acquisition debt, that interest is fully deductible on schedule E against rental income.

For the refinance, you still only have $200K of acquisition debt against $300K total debt, so roughly 2/3 of the interest is deductible.  As you make payments, you can consider that you are paying off the equity debt first.  On July 1, if your acquisition to total debt was $200K/$300K, then 66.6% of your interest for July is deductible.  By December 1, your ratio might be $200K/$290K, meaning that 67.8% of your interest for December is deductible.

Because the percentage of deductible interest changes each month, the IRS provides two ways to calculate the deductible portion.  One method is to average the first and last month balances (in this case, your first month is July, but on your 2022 tax return, your first month is January, of course); the other method is to determine the percentage for each individual month from your statements.

I don't know how well Turbotax will calculate this for you, there are always a few complaints about personal mortgage interest (your residence), so the same issues may apply to calculation of business interest.  You may just want to calculate it yourself and enter the final number.

And of course, if you use some of the equity cash to make improvements to the rental unit, that will increase your acquisition debt. 

[Mac1287]

@Opus 17 : Thank you for the detailed response. Is it always the case that we assume the equity debt is paid first, before the acquisition debt, for tax calculation purposes?

Please let me know if I'm understanding this correctly. Based on your response, the equation would then realistically be more like as follows, assuming that the year-end principal is down to 290K:

(300K + 290K) / 2 = 295K   ==> Average Total Principal from July to December

(200K / 295K) * (Mortgage Interest Paid on 1098 Form from Refi Mortgage Company) + (Mortgage Interest Paid on 1098 Form from Original Mortgage Company)

*This would be applicable to the original rental property that secured the loan*

To go a little further, if we do use all or a portion of the equity (cash-out) to purchase another rental, would the equation be similar to this, assuming we use the entire 100K cash-out in the example:

(100K + 90K) / 2 = 95K   ==> Average Equity Debt Principal from July to December

(95K / 295K) * (Mortgage Interest Paid on 1098 From from Refi Mortgage Company)

*This would be applicable to the newly purchased rental property that didn't secure the loan*

I used the Average of the Equity Debt (which would go from 100K to 90K based on the example) for this equation in order to account for the full mortgage interest balance.

As for the actual numbers, I do plan to figure it all out myself prior to entering into Turbotax as the software doesn't currently have any questionnaires/aides pertaining to this specific question. 

[Opus 17]

@Mac1287 

For residential mortgages, you assume the equity debt is paid down first.  That is preferred because it increases the percentage of interest eligible for the schedule A deduction.  I don't know if this treatment is required--if there was a reason to "pay off" the acquisition debt portion first (to change how interest is allocated) then I suggest a professional consultation, to determine if you can use a different method.

As long as you don't have any new borrowing during the year, you take the average of the first and last month total balance (300+290)/2=295 and the average of the first and last month acquisition debt (200+200)/2=200 and then get the percentage 200/295=0.678 (take it to the third decimal place).  There is a worksheet and illustration in publication 936 that applies to residential mortgages but I believe the formula and principle would be the same when assigning interest to the rental property.  Just ignore the $1 million and $750,000 limitations because they don't apply to business property loans. 

https://www.irs.gov/forms-pubs/about-publication-936

If you use the equity debt to buy new property C or refurbish property A, remember that the interest is only qualified rental interest after you make the purchase or remodel, not for the entire year.  So it might be the case that 32.2% of the interest is equity interest, but if you don't buy property C until June, then only 6/12th of the equity interest can be applied as an expense to property C. 

[Mac1287]

Thank you so much @Opus 17 . This was incredibly helpful.

Do you happen to know if the same "proportioning"/tracing rules also apply to the closing costs (Loan origination fee, Appraisal fee, Title insurance, Transfer taxes, etc.)? Or are those wholly deductible? I understand they would need to be added to the cost basis of the property and ultimately amortized and applied as a depreciation, but would I need to first reduce the amounts per the Acquisition Debt vs Total Debt ratio, like the Mortgage Interest?

I can not find any information from Publications 535 or 936 and Turbotax does not cover this aspect in their "Refinance Expert Tool".