TaxProTalk.com

Had a client who paid 75K for his principal residence from his parents. 4-5 years later he took a cash-out refinance. He began renting out the home he bought and used the funds from the cash-out refinance to put down a down payment on another principal residence that he moved into plus another rental property.

As it pertains to the original property turned into a rental, I believe that he should only get to deduct the portion of the interest expense relating to the the original purchase price since the funds from the cash out refinance went to purchase other. If he paid 75K for the home and has a cash-out refinance of 60K, only 50% of the interest should be deductible doing the math.

Wanted to make sure this sounds reasonable.

I might be misunderstanding, but I think that the interest expense related to the cash-out refi would be traced to only the 2nd home and the 2nd rental property based on the percentage of funds allocated to each.

However, for the 2nd "principal" residence, do you think the interest would be deductible? I don't think it meets the requirements because the home is not collateral on the mortgage that the interest relates to.

Not sure where you get the 50% you mention, but no matter.

If the excess cash from the refinance, above that needed to pay off acquisition indebtedness, is not used to improve rental #1, its not deductible on rental #1. Read up on the tracing rules. The portion allocated to rental #2 may work. The amount used to purchase the primary residence won't as its not secured by the home.

I see rental property refis fairly often, and they are often incorrect. Had a new client last year who had refinanced a rental some years ago and paid off their primary residence. Prior preparer was deducting 100% of the interest on the rental, when only about 20% of the proceeds went to pay off acquisition indebtedness. Oops. Seen that guy's work before and wasn't surprised.

Another thing to look at is the order in which debt is amortized under the rules.

Fun stuff.

Prior preparer was deducting 100% of the interest on the rental...

Too bad some taxpayers fail to realize when they got a good thing going.

Wiles wrote:Prior preparer was deducting 100% of the interest on the rental...

Too bad some taxpayers fail to realize when they got a good thing going.

You mean by filing multiple incorrect returns? Not something I recommend.

So the original financed cost of the original home was 75K. He then did a cash out refinance and received 65K. Out of that 65K, 23K was used as a down payment and to pay the closing costs of the one rental home.

The interest for this loan was $4,700 for 2022

75/140 * 4,700 = 2,518 allocated to original property (now rental)

23/140 * 4,700 = 772 allocated to the other rental property

42K from the cash refinance was used for other items.

It looks like you changed things up from OP, but I agree with you. The 42K will need to be traced to whatever it is.