Deductibiity of interest on a larger refinanced mortgage on a rental property

[mpsingh08]

If I were to refinance a rental property with a larger loan, using the cash out for another investment, can I deduct the interest on the new (larger) mortgage on the rental property? 

[AmeliesUncle · Accepted solution]

No, you can only deduct the portion for the rental property. 

A rental deduction is for a rental property expense.  If the expense is for something else (such as "another investment"), it is not a rental expense.

Depending on what that "another investment" is, it is possible the interest associated with that may be deductible (or possibly capitalized) for that investment.

[Anonymous]

for example, if you use the excess to start a personal business under IRS tracing rules, it would be deductible on schedule C.  if it was used to buy stocks it would be subject to investment interest limitation form 4952.

If the borrowed funds are commingled with other funds that were not borrowed (“un-borrowed
funds”), then potential interest deductions on the loan can be lost. Basically, separate accounts
for one’s business, rental properties, investments, and personal affairs must be kept. Do not
commingle borrowed funds with un-borrowed funds. Try not to use the borrowed monies for
personal expenditures. If one wants to borrow to buy a personal-use item, make the purchase
first from the savings account, then restore the savings account with the borrowed money. In
this scenario, the savings account is an “investment,” and therefore, the loan interest is
deductible as investment interest (which is better than it being nondeductible personal interest).

[Carl]

When you "cash out" on refinancing rental property, the interest on the cash out amount is "NOT" a deductible rental expense. Period. Here's a simplified example.

You refinance a rental property in 2019 and at the time of the refi you owed $50K on the original loan. You refi for $100K, then use $50K to pay off the original loan and the other $50K you put in your wallet. With this scenario, only 50% of the mortgage interest on the new loan is deductible as a rental expense on the SCH E for the life of that loan. That's it.

Now lets say you used $10K of the cash out amount to improve the rental property and pocketed the remaining $40K (or did something else with it not related to the rental property). That would mean you can claim 60% of the mortgage interest on the new loan over the life of that loan, as a SCH E expense.

What you do with the remaining cash-out amount has no bearing on the SCH E. Weather you can claim/deduct the interest on it depends on what you do with it. But it won't be a SCH E expense.

[mpsingh08]

Thanks for the guidance. I would like to ask your opinion about the specifc situation. I am thinking of refinancing the mortgage on one of my investment properties (a rental house) to get some cash to use as a down payment for the purchase of another investent property. There would be three other factors to consider:

First, if needed, I will have to add some of my own cash to the 'cash out' from refinancing. I thought that this would not create any complexity, but now, after reading your point about 'comingling funds' I am not sure.

Second, there would definietly be some time lag (at least a few months) between refinancing and the purchase of another invstment property. I thought that I would not be allowed to use the interest payment on the cash out portion of refinancing as an allowable dedctible expense until I purchase the new invesment property, e.g., if it took me 6 months after refinancing to purchase another invstment property I would not be able to claim the interest payment on the cash out portion of refinancing for those 6 months (but after that I would be able to claim tax deduction for the cash out portin of refinancing).

Third, if a deduction for the cash out portion of refinancing is allowed, I will have to show that against the new investment property because I cannot increase the mortgage liabilty for the existing investment property. 

Will truly appreciate your specific guidance on these points. 

[Anonymous · Accepted solution]

my thoughts on this are as follows.    

i would put the cash-out into a separate a/c just to keep things clean should the IRS ever question what you did with it.  This is what is referred to as the tracing rules.  for the period the cash-out portion is not used for another property or investment purpose (such as buying stocks but this portion would then be investment interest subject to investment interest deduction limitations - schedule A), the interest would be nondeductible personal interest.  so when it comes time to buy the new property putting in personal cash on top of the cash-out should be easy to demonstrate should the IRS inquire

[mpsingh08]

Thanks! Very clear and easy to follow guidance.