Should I use a cash out refi on my residence to pay off mortgage on my rental property?

[KKAUSTIN]

I'm refinancing my home (to 3.0% from current 4.125%) and was planning on taking cash out to pay off my rental property (current 4.5%).   I'm not sure this makes sense though, given that I deduct my rental property mortgage interest but not my home mortgage interest (I've been using the standard deduction on my return).  I'll save on the overall interest I'm paying on the two houses, but I'm losing the deduction that offsets my rental income.  Can anyone tell me the calculation needed to make this decision?  I'm in the 22% tax bracket.

[Critter-3 · Accepted solution]

If you will have only one mortgage on the personal residence that will also cover the rental  then using the tracing rules you can still  apply the rental portion of the interest to the rental. 

For instance if the new mortgage was 40% used to pay off the rental mortgage then 40% of the interest can be applied to the Sch E  and 60% to the Sch A... keep good records if the IRS comes asking for it. 

[Carl]

You can do anything you want with the cash out. The IRS could care less. However, the interest you pay on the cash out amount is "NOT" deductible on SCH A as an itemized deduction.

If you use all of that cash out to pay off a rental, then you can deduct the percentage of mortgage interest that applies to that amount on SCH E, and that could actually be beneficial down the road. Just understand that the tracing rules apply in case the IRS every questions you or audits you on it. Three rules to keep in mind on this stuff when dealing with the IRS:

1) You are GUILTY until proven innocent.

2) The burden of proof is on the accussed (that would be you!) and not the accuser.

3) If it's not in writing, then it *did* *not* *occur*.

[Critter-3]

OP stated he was refinancing the personal residence and also taking out equity to pay off the rental loan ... in that case personal part would still go on the Sch A and the rental part to the Sch E. 

[KKAUSTIN]

Great, thanks for enlightening me!  I had never heard of the tracing rules.