Cash-out refinance on primary residence to buy a rental property

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I recently refinanced my primary residence and purchased an investment property. Initially, I was planning to cash-out my primary residence through refinance and use the money to make a down payment for the rental house. However, the refinance took more than 5 months to close, which is 3 weeks after I closed my rental purchase. When I do my tax return next year, can I still claim the interest and closing cost from the refinance as the expense for my investment property?

If the answer is yes, how much interest can I claim as the expense of investment? My primary house before refinance had a balance of 90K, I took out 65K and the new balance after refinance is 162K. The down payment for the investment property is only 40K. Since I cashed 65K I am planning to use the 25K to purchase another investment in the near future. If you happen to have any citation from the IRS it would be great! Thank you for your help in advance!

JulieSAnswer

Alumni - Intuit

I cashed out my Primary Residence and bought a rental house last year. Now I received a 1098 for my primary residence. Since I believe 60% of the interest is for my primary home so 60% should go to SCH A while the 40% should go to the rental house's SCH E. I am not sure how to handle it using TurboTax 2022, and not sure if I can claim 40% of RE taxes of my primary residence to the rental house's SCH E as well.

No, you can't claim 40% of your primary home's real estate tax as a rental expense.

As was covered in prior posts, you can enter 40% of your mortgage interest, since that money was used to buy the rental.

You claim your rental unit's real estate tax as a rental expense and you claim your home's real estate tax as a personal deduction on Schedule A.

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M-MTax

Level 15

What would be deductible is whatever amount of the loan you can trace to the purchase of your investment property.

Carl

Level 11

However, the refinance took more than 5 months to close, which is 3 weeks after I closed my rental purchase.

That indicates to me that not one single penny of the cash out was used to purchase the rental property. Therefore nothing is deductible against the rental. But maybe there's something about the transaction you're not telling us?

can I still claim the interest and closing cost from the refinance as the expense for my investment property?

Based solely in the information provided, the unfortunate answer is no. Like I said, maybe there are some details you left out?

My primary house before refinance had a balance of 90K, I took out 65K and the new balance after refinance is 162K.

Since your balance before refinance was 90K, that's 55% of the refi. Therefore 55% of your interest is a SCH A itemized deduction against the primary residence, every year until paid off.

Since I cashed 65K I am planning to use the 25K to purchase another investment in the near future.

That $25K would be 6.5% of the total refi amount. Therefore 6.5% of the interest paid every year would be a SCH E deduction.

Chris2Author

Level 3

Thank you so much for your detailed response @Carl11_2

I started the refinance in June 2020 and hoping to use the cash-out money as a downpayment for an investment that closes in late October 2020. I was confident that the refinance would be done before the purchase but I was wrong. The refinance was not done until November 2020. I end up using my savings to make the downpayment for the purchase. However, I started the refinance 3 months earlier than the purchase and my intention is to use the cash-out refinance for this investment. Do you think I may still able to deduct the interest and fees against the rental?

If the answer is no, I am still planning to use the money to buy more rental. If I use 40K in December 2020, and 25K in March next year, how should I do the calculation for tax-deductible against the rental income? I am not sure how to prove it that I use the 65K cash-out money for investment purpose and how to handle the timing when calculating the deductible taxes. Thank you so much for your time!!

Carl

Level 11

I see you're trying to create loopholes where they don't exist. 🙂 You're not the first, and won't be the last.

When you started the refi of your primary residence is irrelevant. Doesn't matter if it took you 5 minutes, 5 months or 5 years to close on that refi either. All that matters is the closing date, and not much else.

Fact: You did not have any control or possession of the cash out money prior to closing on the rental property. Therefore there is no possible way you could have used that money towards the purchase of the rental. Period. End of story.

Opinion: If you claim the use of any of that money towards the purchase of the rental you closed on, before you closed on the refi, if/when the IRS audits you and catches it, it will be costly for you. It is not at all uncommon for what is referred to as a "paper audit" to occur 4 or more years down the road. (I've seen some audited as far back as 9-10 years, and a small few more than that.) If/when that happens to you, then you'll owe back taxes, fines, penalties and late fees for each and every tax year you claimed that interest. My advice is, don't do it.Rest assured that if the IRS comes knocking on this, you will lose the argument.

FACT: if you plan to purchase another rental using some of that refi money, don't wait to long. The IRS expects any reinvestment of a cash out to be done in a "reasonable" time frame.

OPINION: I've never been able to find any definition of what the IRS considers "reasonable". I would "expect" within 6 months to be reasonable. But the IRS may expect differently for all we know.