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tearlach99
Level 1

How does the IRS determine whether "cash out" has been taken from a loan?

We had a main mortgage loan for the house, and a second mortgage as well. None of the money from the second mortgage was used for home improvements.

In 2020 we refinanced and rolled both loans into the refinance loan so that we now have a single loan for the house. I've followed the steps for entering multiple 1098s (there were 3 of them), and now TurboTax is asking me whether I ever took any cash out of the refinance loan.

Since the money from 2nd mortgage loan (which was rolled into the refinance loan) was not used for home improvements, is the amount of the refinance loan used to pay for the 2nd mortgage loan considered as cash out? For example, if my second mortgage loan was for $27,000.00, does the IRS view that amount as cash taken out of the total refinance in order to pay for the 2nd mortgage that was rolled into the refinance loan?

2 Replies
Opus 17
Level 15

How does the IRS determine whether "cash out" has been taken from a loan?

Your interest is not fully deductible, but it sounds like you will have to make some manual adjustments.  The IRS has no automatic way of knowing you claimed too much interest deduction, but if audited, you will have to prove how the money was used, and any disallowed deduction will result in back taxes with interest.

 

You can deduct mortgage interest on acquisition debt.  Acquisition debt is debt used to buy, build or substantially improve your home.  You have to trace all the money from each loan.  For example:

 

Loan 1 is the purchase mortgage, used only to buy the home.

Loan 2 is an equity loan that was not used to buy, build or improve the home.

In 2020, you refinanced to a single loan 3.  Assume the balance on loan 1 was $150,000, the balance on loan 2 was $27,000 and the balance on loan 3 is $177,000.  Your acquisition debt is $150,000, so only 84% of the interest on loan 3 is tax-deductible.  100% of the interest on loan 1 (that you paid before the refinance) is deductible, and none of the interest on loan 2 is deductible.

 

Turbotax may not do a good job of calculating deductible interest in your situation, but I have not tested this situation.  If you can answer the questions to get this result, it's correct. But if it seems wrong, you may need to get more help on how to enter the correct amount of deductible interest.  

 

Next year, you can assume that you are paying off the equity portion first.  So in my example, your loan as of January might be 84% acquisition debt (150,000/177,000) and by December, it might be 88% acquisition debt (if you paid off $7000 of the equity portion and the loan was now 150,000 acquisition/170,000 total).

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
Carl
Level 15

How does the IRS determine whether "cash out" has been taken from a loan?

We had a main mortgage loan for the house, and a second mortgage as well. None of the money from the second mortgage was used for home improvements.

The interest paid on the 2nd loan is flat out not deductible.

In 2020 we refinanced and rolled both loans into the refinance loan so that we now have a single loan for the house.

So the percentage of the interest that is equal to the percentage of money used to pay off the "ORIGINAL" loan, is all you can claim as an itemized deduction on the SCH A.

If the new loan is $100,000 and the "ORIGINAL" loan balance at the time of the refi was $60,000, then you used 60% of the new loan to pay off the original loan. Therefore, only 60% of the interest is deductible on the SCH A every year, for the life of the loan.

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