Cash Out Refinance to consolidate 2 home loans

[taxaderm]

When I purchased my homeA, I did so using the following:

1. Down payment
2. Loan under my name for the homeA
3. Cash-out refinance loan under my parents name on their homeB.

I have been paying off the loan under homeA and under homeB and deducting mortgage interest since the beginning of those loans. When I had a CPA at the beginning, she confirmed that this was appropriate. 

This year I would like to do a new cash-out refinance under homeA to fully payoff the loan for homeB. I understand that in typical circumstance, a interest on the cash-out portion is only deductible if it is used to improve the home. However, in this case I am consolidating 2 loans on my home and would not be using the cash for any other purpose. Would I still be able to deduct the full interest of the new cash-out refinance on homeA?

[Vanessa A]

Yes, if you are refinancing the portion of loan on home B that was originally used to purchase Home A and consolidating it with the loan for Home A, you would be able to deduct the interest as all of this money was originally used to purchase Home A. Nothing has changed with the use of the money, the only thing that changed is where the payments are being made.  

[taxaderm]

Just to be clear, I want to do a cash-out refinance on homeA. The cash-out amount would be equal to or lesser than the principal of the loan on homeB. I will then use the cash-out to fully pay and close the loan on homeB. This would effectively result in a loan on homeA with the principal being originalHomeA-principal + originalHomeB-principal.

So the interest on the new loan on homeA would then be fully deductible because the use of the money has remained the same? The same being "a loan against the homeA"?

[Vanessa A · Accepted solution]

If the full amount of loan B was originally used to pay for part of Home A, then yes.  If not, then no. 

Say Loan B has a balance of $100,000.  Home A had an original balance of $225,000, all of which was used to purchase Home A, but it now down to $175,000. The original amount you took out of Home B was $120,000 and you have paid it down to $100,000, again, all of this was used to purchase Home A.  You are going to take $100,000 out of Home A to pay the $100,000 you still owe on the balance that was all used to buy Home A.  Your new loan amount will be $275,000 (100K+175K) .  In this scenario, the interest on the entire $275,000 is tax deductible.  You are simply consolidating the loans.

Say however, home B has a balance of $100,000, but the original balance was $150,000.  This consisted of $75,000 remaining balance on Home B's loan and $75,000 for home A.  You then still owe $175,000 on the Home A loan which was used entirely to buy Home A. Your new loan for Home A will still be $275,000, however, interest on $50,000 of that loan will not be deductible since half of the original loan was originally used to pay for Home B.  Only the interest on the $225,000 that was directly used to purchase Home A would be deductible. 

Any amount that was originally used to purchase Home A is deductible.

[taxaderm]

You're awesome @Vanessa A ! Thank you for making it so clear!