Cash our refinance tax deduction

[Beaglejazz]

Hi, 

I am thinking of a cash our refinance, pulling $200k out on top of a $500k outstanding balance. We will use it on various home improvement projects... the largest being an addition. My question is if we refinance now but don’t do the addition for another 8 months or so, can I still deduct all the interest of the $200k? Or do you only deduct on what I have actually paid thus far (ie arch fees, permits, but not construction?) we are trying to take advantage of the low interest rate which is why we are doing the refinance now... plus, it costs $ to do all the design work, etc!

Thanks!

[DavidD66]

You can refinance now and deduct the interest as long as the expenditures to improve the your home occur within 24 months of the loan date.

[Beaglejazz]

Thank you so much @DavidD66 

if I may, two quick follow ups...

1) if I have expenditures that qualify PRIOR to closing (ie 1-4 months) of the refinance that I have paid in cash/credit card for, can I claim them as a part of the deduction 

2) if I end up using less than the full cash out amount and then pay he loan down by that amount (ie take out $200k but end up only needing $150k so pay back $50k to bring loan balance down) will I still be able to fully deduct the interest? Given that the prepayment likely won’t be a recast of the loan but rather end up shortening the term on the back end, I am unclear if I can fully deduct the full interest.

thank you!

[NCperson]

@DavidD66 - can you please evidence where the 24 month rule is stated.  That is the first i have ever heard that and do NOT see it in Publication 936.  Based on what I provide below, I challenge the advice on this topic and would encourage @Beaglejazz to review the publication itself. 

https://www.irs.gov/pub/irs-pdf/p936.pdf

what it does say is this: (bottom left page 10)

You build or substantially improve your home and take out the mortgage before the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within 24 months before  the date of the mortgage.

but what that means is improvements that occurred in the 24 months before you borrow the money qualified as improvement expenses. It does NOT mean you can deduct the interest BEFORE you improve the home. 

So let's say you borrow the $200,000 and do no improvements in Year 1, $50,000 of improvements in Year 2 and $150,000 of improvements in Year 3.  

In year one, the interest is NOT deductible.

In year 2 ,  1/4 of the interest ($50 / $200) is deductible

in year 3. all the interest is deductible. 

[NCperson]

again, see publication 

https://www.irs.gov/pub/irs-pdf/p936.pdf

1) look at the top of page 10 (in the middle). 

You build or substantially improve your home and take out the mortgage within 90 days after the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage. (See Example 2, later.)

so the expenses you incur in the 24 months leading up to the date you take out the mortgage that were used to improve your home are eligible.  

2) no. See my other post. let's say in Year 1 you borrow the $200,000 immediately use $150,000 for the improvements.  3/4 of the Year 1 interest is deductible.   Then at the end of the year, you realize you'll never need the remaining $50,000 and repay it to the bank.  While the payment won't change (as you note), the interest will go down and the principle payment will go up substantially which is why the loan gets paid off earlier.  in Year 2 and forward, 100% of the interest is deductible as the 100% is related to the $150,000.  The IRS assumes personal debt ($50,000) is paid back before qualified secure debt ($150,000) ; they do not assume pro-ration.

[Opus 17 · Accepted solution]

I believe @DavidD66 is most generally correct, but its complicated.

First, you must remember that the 3 rules you quote from are preceded by a qualifier: "A mortgage secured by a qualified home may be treated as home acquisition debt, even if you don't actually use the proceeds to buy, build, or substantially improve the home."  This is designed to capture a situation where, for example, a homeowner pays for an improvement from their savings, then has a financial crisis and decides to refinance to have the cash back.  The rules consider a "what-if scenario": What if the homeowner had left their savings alone, refinanced to pay for the improvements, and saved the cash in the bank to use for the emergency.  The rules you quote set time limits on the ability to treat the refinanced proceeds as if they were used to pay for the improvement. 

Here, the taxpayer will use the proceeds to pay for the improvement, but at a later date.

Second, the actual law is silent on any time limits.  The law is at 26 USC § 163(h)(3).

Remember that Congress passes the law, then the IRS writes regulations to implement the law, then they write publications to explain the regulations.  If there is any disagreement between the publications, regulations and law, the law controls.  In this case, the IRS seems to have written some rules to interpret the difference between acquisition debt and equity debt that was created in the 1987 law but not further defined. 

So we have a situation where the money is borrowed in January and used to pay for an improvement in July.  (This is not necessarily even unusual, a big renovation can take months, and you might pay 1/3 in advance, 1/3 on start and 1/3 on completion, or an even more spread out milestone payments.  It can't be that on a 6 month remodeling job, the 1/3 deposit is qualified debt but the 2/3 paid later is not.  The only difference here is that the taxpayer is planning on a delay, rather than having one forced on him or her by the contractor.)

Since the law is silent on the issue, and the regulations discuss a 24 month rule connected to other situations but not this one, applying a 24 rule here is reasonable** and the money would be treatable as acquisition debt if the refinance occurred in January and the money was set aside and used for construction in July (or within 24 months probably.)  However, you would want to be very careful about not using the money in the mean time.  I think if you invested the money in the stock market for 23 months, then pulled it out to pay for an improvement, you might be in real hot water.  Then you would be dealing with the situation where "A mortgage secured by a qualified home may be treated as home acquisition debt, even if you don't actually use the proceeds to buy, build, or substantially improve the home" and the special rules would definitely apply. 

One point of note is that interest paid from January until July is NOT qualified acquisition debt and not deductible, even if the money is later used to pay for an improvement (the interest becomes deductible after the improvement is paid for but not before.  Turbotax won't help you with this calculation, you have to keep track yourself.

And of course, when in doubt, pay for professional tax advice.

**Even more generally, tax courts use concepts like connection, reasonableness, and substance over form (what really happened rather than how you made it look).  If the loan is clearly connected to the work, it is likely to pass if audited.  Such as, you refinance the house, and put half the proceeds in a savings account while you get estimates, then use the savings to pay for the improvement.  There is a clear connection between loan and improvement, and the court is not likely to object to a reasonable time period to get estimates, hire the contractor, and get on their schedule.  On the other hand, if you refinance, use all the money to pay off credit cards, then 6 months from now use a credit card to add a deck on your house and decide you want to get a deduction after all, you've lost that definite connection between loan and use, and your interest deduction would be on shakier ground.