Rental mortgage interest deduction if using saving to pay for rental mortgage principle but then make a cash-out refinance for a personal issue.

[LTV]

I have some cash in saving of which interest saving is almost zero while I also have a mortgage on my rental of which interest has been deducted from my rental income. I am wondering if now I use $50k of my saving to pay for part of my rental mortgage principle, but later I do a $50k cash-out refinance from my mortgage on the rental for a personal project. Can I still get tax deduction for the interest amount charged on the $50k cash-out?

[Carl]

Can I still get tax deduction for the interest amount charged on the $50k cash-out?

No. lets say you originally purhcased the property for $100,000. You put $20,000 down and financed $80,000. Interest you pay each year on that $80,000 is tax deductible mortgage interest.

A few years later you owe $60,000 on the property. You refinance the property for $110,000 and "cash out" $50,000. You can only deduct the interest paid on the $60,000 part of the mortgage that was actually refinanced. The interest on the remaining $50,000  you cashed out is not deductible.

Now if you use that $50,000 to repair or improve that rental property you refinanced, then you can deduct the interest on the entire refinanced amount. But since you state you're going to use the $50K cash out for "other purposes", the interest on that cash out is not deductible anywhere on your tax return.

Using my numbers above, if I refinance at $110,000 and "cash out" $50K, that means I can only claim/deduct 55% of the interest I pay on that loan each year, since I "cashed out" 45% of the money and did not use it to do anything to the rental property I refinanced.

[LTV]

Thank you so much Carl.

[jdbollinger]

Thank you for this example.  Can you clarify, is that 55% of the interest that you can deduct fixed over time (so that is the percentage you would be able to deduct in future years as well)?  Or can you pay down the non-deductible portion first so that the percentage you can deduct would grow over time?  In case that isn't clear, the example would be, now from that loan of $110,000 you have paid off $20,000 so the remaining balance is $90,000.  Are you able to deduct 66.7% ($60,000/$90,000) of interest or do you still have to deduct only 55%?

[DianeW777]

No, you cannot 'pay down' the nondeductible portion.  You will always use the percentage determined from the time of refinance for the portion of the loan that was used to buy, build or improve the rental property.  Amounts used for personal purposes is not deductible. 

The interest is deductible when paid at the percentage allowable.  You cannot alter when and how you want to deduct the interest.

[jdbollinger]

Great, thank you for clarifying!