Mortgage refinance with cash out to pay off 401k loan

[MogulMan]

In 2014 I took a loan against my 401k for the down payment. In 2020 I refinanced my mortgage and took only enough cash out to payoff the remaining balance of the 401k loan (which was only used to purchase the house). Is that considered a "housing expense" and allow me to deduct all of the interest of the new mortgage loan?

[Opus 17 · Accepted solution]

On the face of it, yes, but you would be at risk in case of an audit. Acquisition debt is debt used to buy, build, or make substantial improvements to your home. Acquisition debt does not have to be a registered mortgage.  However, the debt must be fully traceable. You must be able to show that every dollar of the refinanced mortgage, except for perhaps closing costs, can be traced back through the 401(k) loan to the original purchase.  If you used the 401(k) loan for anything else, this will weaken your tracing ability.

From the way you asked the question, it sounds like you can trace the debt successfully, so you would have a good chance of prevailing if you were audited. You should keep records of the purchase, the 401(k) loan, and the refinance that shows your ability to trace the debt, for as long as you own the home and at least three years after you sell. Don’t discard the 401(k) paperwork because you think it is too old to bother about.