How do I enter a cash-out refinance on a rental property?

[jotheturtle]

I refinanced my rental property and took a cash out that is approximately equal to my outstanding loan balance. My understanding is that I can only deduct half my mortgage interest as a result. Do I only enter half the mortgage interest on my 1098 entry? Or do I account for this some other way? I don't see any page that asks me about a cash out refinance specifically :(

[MaryK4]

You do not have to report information on a refinance, you are correct that you deduct the interest- do not change the 1098 for the entry.  

[Carl]

you do not have to report information on a refinance, you are correct that you deduct the interest- do not change the 1098 for the entry.

My interpretation of the above statement is contradictory, based on my interpretation of the question.  So let's clarify things a bit here, to help ensure accuracy and understanding by all parties on all fronts.

I refinanced my rental property and took a cash out that is approximately equal to my outstanding loan balance.

My interpretation of the above is understood to be as I've reworded the question below.

I refinanced my rental property for approximately double what I owe on it.

If my interpretation is correct, then at this point in this post, you can only deduct on the SCH E that percentage of mortgage interest that is equal to the percentage of the amount refinanced, that was used to pay off the first loan. Example:

Refinanced on 7/1/2020 for a total loan amount of $100,000.

$50,000 of that $100,000 was used to pay off the original loan.

I have $50,000 cash left, that I can do anything I want to with.

With the above example, I can only deduct 50% of the mortgage interest on the refi loan, for the entire life of that loan. The other 50% of mortgage interest is just flat out not deductible. Period.

Now, there are things that "could" allow you to deduct more than 50% of that interest. For example, if you used $25,000 of the cash out money to put a new roof on the rental property, that's a property improvement. So that means you now have a total of $75,000 invested into the property. That's 75% of the refi loan. Therefore, you can claim a maximum of 75% of the interest on that loan every single year, for the life of the loan. This is but one example of many possibilities that would allow you to deduct a higher percentage of the mortgage interest on the SCH E. It's also possible that if you use any of that cash to improve your primary residence, then a corresponding percentage of that interest could be claimed as a SCH A itemized deduction.

[jotheturtle]

Thanks @Carl! I understand what you're saying and I understand that I would only deduct on the SCH E that percentage of mortgage interest that is equal to the percentage of the amount refinanced. In my case, that is 54%. What I'm wondering is, how do I do enter that in TurboTax? Do I only enter 54% of the number shown on my 1098? Or is there some other place where I say, hey TurboTax, please deduct only 54%?

[Carl]

Do I only enter 54% of the number shown on my 1098?

Yes, exactly. Note that with business property (which is what rental property is) the only number you will enter in the SCH E section is 54% of the amount shown in box 1 of that 1098. If any of the remaining 46% of interest doesn't qualify as a SCH A itemized deduction, then none of the other boxes on that particular 1098 will be entered anywhere in the program.

Now if you used any part of that remaining 46% of the money (your cash out amount) for something directly related to the rental or other business property you own, let me know what you used it for and we'll see if we can increase that 54% you can claim on SCH E, legally.

If you used any portion of the 46% cashed out for something on your primary residence or other "personal use" real estate that you own, let me know what it was, and we'll see if any of that 46% can be claimed as a SCH A itemized deduction.

[jotheturtle]

Thank you @Carl!!!! I was nervous to type in 54% of the 1098 number in the box, when the instructions say to type the 1098 number in the box and don't mention needing to adjust it outside of TurboTax. But now I know, I just multiply my 1098 number by 54% for the duration of the loan.

I *am* using some of the "extra" 46% to do repairs/upgrades on my primary residence. But I thought those don't count, because it's not a part of my business? (I mean, it's slightly related I suppose - I manage my investment property from my primary residence and therefore my primary residence needs to be maintained in order to serve as an office space...)

[Carl]

Okay, so lets check out if that left over 46% can be claimed as a SCH A itemized deduction. First things first though.

I manage my investment property from my primary residence and therefore my primary residence needs to be maintained in order to serve as an office space...)

Be aware that a home office for "residential" rental property is not allowed. But maybe you have other "commercial" property that you rent out? Or maybe a SCH C business you own?

I *am* using some of the "extra" 46% to do repairs/upgrades on my primary residence.

You "may" have some qualifying things then. In the words of the IRS, did you use any of that cash out money to "buy, build, or substantially improve" your primary residence?

[jotheturtle]

Oh I see! Ok so it's mildly complicated with the primary residence. We bought the primary residence with a relatively smaller loan than one might otherwise have, and then refinanced with cash out a month later. So the money didn't directly go into our down payment, but it did help us buy our primary residence by immediately after the fact allowing us to replenish the money that had gone into the down payment.

After that we paid for a bunch of upgrades, which are still ongoing into 2021, things like repainting everything, ripping out carpets and refinishing the floor, buying lots of furniture, fixing some minor electrical issues, replacing broken windows, etc. We will likely also redo the shed.

We might also want to upgrade our electrical panel and install new heating and cooling. We were going to wait a couple years to do that, but if it's a big tax break to use the cash out money on that upgrade now, we'd definitely consider doing it now!

[Carl]

the money didn't directly go into our down payment,

Unfortunately, that doesn't count, since you closed on the primary residence before you closed on the rental property refi.

we paid for a bunch of upgrades, which are still ongoing into 2021,

Some (not all) of those count for this.

ripping out carpets and refinishing the floor, fixing some minor electrical issues, replacing broken windows, etc.

Only those I included above, I know for a fact, count. Only those items that you actually paid for in tax year 2020 can be included on your 2020 tax return.

We will likely also redo the shed.

We might also want to upgrade our electrical panel and install new heating and cooling.

That will count also. But not on your 2020 tax return since you didn't pay for it in 2020.

One thing that is important with this, is that you must be able to "track the flow" of the money. So keep that money in the bank until it's time to use it for a "qualified" expense. Don't go spending it on something else, as that will "break" the flow and could disqualify the claim

Note also that all this money you spend for qualified upgrades, also increases the cost basis of your primary residence. So keep track of your actual costs. They will come into play and be benificial to you on the tax front, when/if you sell your primary residence in the future. (Or even if you convert it to a rental in the future.)

As an example:

Lets say you spent 20% of the total refi amount for refinishing the the floor, electrical issues and window replacements and paid for them in 2020. You can claim 20% of the interest on the loan as a SCH A itemized deduction on your 2020 tax return as well as on all future tax returns for the life of "that" loan.

Now lets say in 2021 (this year) you spend another 15% on a new HVAC and redoing the shed. On your 2021 return you can deduct 35% of the mortgage interest paid on the return, and you can do so for all future returns for the life of the loan.

Now for a note on this. As I'm sure you're aware, your SCH A itemized deductions make no difference to your tax liability until those itemized deductions exceed your standard deduction. For tax year 2020 the standard deduction for a married couple filing joint is $24,800. So it takes one heck of a lot of itemized deductions to exceed your standard. But claim what you can on SCH A anyway. Two reasons for this.

1) It "might" make a difference on your state tax return if you're required to file one, as states have their own "standard deduction/itemized deduction" rules and dollar amount limits and thresholds.

2) If you have something such as a costly unforseen and costly medical emergency, (medical expenses are SCH A itemized) that medical expense, combined with your other SCH A deductions just might put you "over the top" and your itemized deductions could reduce your tax liability quite substantially on the federal return in that tax year.

[jotheturtle]

Wow!! And thank you!!!!! I will look for TurboTax to prompt me to enter these deductions when I get to the deductions tab with charitable donations etc. And I'll only enter durable things, not stuff like repainting.

I've put the money into stocks, because it's a lot of money to leave sitting in cash, but it's in its own bank account, not mixed with any other money. Is that ok or did I mess things up big time by putting it into stocks? And do I have to sell those stocks to pay for upgrades so it's really directly obvious, or is it ok if I just keep a spreadsheet but sometimes my husband writes the check from a different account? Yikes this is complicated...

[Carl]

Yikes this is complicated..

Not really. But it can "get" complicated if one doesn't pay attention to details. There would really be no reason to sell stocks to prove flow of money in your specific scenario. Example:

You put $20,000 of the cash out in stocks in 2020.

From 2020 - 2021 you "save up" $20,000 in your savings account. Then in 2022 you use that $20,000 from savings to put a new roof on your primary residence. You would be on paper "basically" be swapping that $20K in savings, with the $20K in stocks to pay for the new roof.

[jotheturtle]

Ah ok! That's quite sensible! One last thing... Do you know what the rule is that says I can deduct my primary residence improvement costs so long as they were funded by the cash out on my investment property? I am searching online and not finding the source, which I think would be good to have handy just in case!

Again, this is so helpful, thank you!!!

[Carl]

Do you know what the rule is that says I can deduct my primary residence improvement costs so long as they were funded by the cash out on my investment property?

You can't do that with a primary residence. That's only possible with improvements to some type of business property (such as rental property).

Qualified property improvements to your primary residence add to the cost basis of that property. But you don't deal with it on any tax return until:

1) You sell the property
2) You convert the property to some type of business use (such as rental, or claim a home office)

3) You die.

Now it "is" possible to get "energy credits" for things you do to your primary residence in the tax year you do the improvement and pay for it. To understand what I'm referring to here, see https://www.irs.gov/newsroom/energy-incentives-for-individuals-residential-property-updated-question...

[jotheturtle]

Oh, now I'm very confused! I thought you said: If you used any portion of the 46% cashed out for something on your primary residence or other "personal use" real estate that you own, let me know what it was, and we'll see if any of that 46% can be claimed as a SCH A itemized deduction.

So I thought based on that I could deduct the cost for adding air conditioning etc to my primary residence. But now you'd saying I can't?

[Carl]

we'll see if any of that 46% can be claimed as a SCH A itemized deduction.

.... if any of the 46% of the interest that applies to the cash out money can be claimed as a SCH A itemized deduction.