Cash out refi to buy personal residence - good tax benefits?

9 Replies

We are going to build a personal home. We have a lot of equity spread out over 13 of rental properties, and we don't qualify for a home mortgage to be sold on the secondary market due to so much self-employment income. That leaves portfolio home loans, and the interest rates on them are not great (4.6% with a 3 year ARM). An idea that occurred to me is the possibility of putting these 13 rentals into one bigloan and doing a cash out refi to cover a large part of the cost of our build, with the thought that the interest would then be deductible, which might have some tax benefits. With 5 kids, we don't itemize, because the standard deduction is so high, so mortgage interest doesn't benefit us. Am I missing something or is this possibly a good idea for the interest deduction reason? Also, the mortgage payment after a large cash out re-fi would be the same as we currently pay on the various mortgages we currently have on our rentals, so our cash flow would be unaffected.

Thoughts appreciated!

This is a question for a CPA but you may want to wait to talk with one until after the tax reform bill that was proposed today is either passed or rejected. The bill as proposed is only going to allow a mortgage interest deduction on a loan of $500k or less. So it would depend on the amount of debt you are looking to consolidate.

Erin - If I understand you want to cash out the refinance on the rentals to pay for your new home.  The interest that you pay (mortgage on the rentals) would be deductible?   

The interest follows where your money is used from the cash out.  Therefore the money that you pulled out of the rentals and put towards the personal residence would be an itemized deduction.  You should bifurcate the total interest of the cash out and put some towards the rentals and the appropriate amount towards your personal residence. 

I know you mentioned you don't itemize on your tax return.  However standard deduction is a set limit for a single taxpayer or married filed jointly.  Your personal exemption will change based upon how many people you claim on your tax return (you, husband and kids).  If you think you might not be able to itemize on your return there are some other ways you could benefit from that interest.  You said you were a self employed individual.  You might be able to claim some of that with a home office.  

You will want to discuss all the details with your CPA/tax preparer.  If you would like to talk or discuss some more planning options, please feel free to reach out.  I am a CPA located in Ohio and can help. 

Thanks for the suggestion - we are below that threshold anyway, but do you understand it to apply to more than just home mortgages? I would have guessed that new limit to not apply to business mortgage deductions. That's a terrible reform for investors if that is the case.  

@Phillip Weickert - okay, so you mentioned the part that I was missing. I didn't realize that the deductions follow what the cash out money is used for. Makes sense. I was just thinking that *any* interest paid on a mortgage secured by rental properties was deductible on schedule E, but sounds like that is not the case.  

So to expand on that concept - suppose I have a rental property that is worth $200k and I owe $50k on it. I do a cash out refi and pull out $50k to put an addition on my residence.  Now I am paying interest on the $100k mortgage going forward.  My schedule E will only get to claim one half of the mortgage interest, correct?  But if I used the cash out $$ to improve a rental property, 100% will be deductible?  

Thanks for your time and thoughts!

@Erin K. That is correct on your example.  If you use 50% towards personal then it becomes an itemized Deduction, however if you use that 50% towards rental property (improvements, buy another, etc), then the mortgage interest would be deductible on Schedule E.  The money spent on the rental "could potentially" be deductible or capitalized depending on the improvement.

Originally posted by @Spencer Karr :

This is a question for a CPA but you may want to wait to talk with one until after the tax reform bill that was proposed today is either passed or rejected. The bill as proposed is only going to allow a mortgage interest deduction on a loan of $500k or less. So it would depend on the amount of debt you are looking to consolidate.

She stated that she doesn't take the home mortgage deduction. A portfolio loan for rental properties wouldn't be affected by a cap on the personal mortgage interest deduction. Regardless of whether it gets passed, I don't think it affects her situation.

As far as other people considering the effects of this bill. There is already a cap, so people can deduct interest only up to the first $1M of a personal home mortgage value. The bill would change that to interest on the first $500K loan vale. The bill has a provision to grandfather in anyone who currently has a loan. So to your point about waiting, it would actually be better for someone to refinance now rather than wait.

Originally posted by @Phillip Weickert :

@Erin K. That is correct on your example.  If you use 50% towards personal then it becomes an itemized Deduction, however if you use that 50% towards rental property (improvements, buy another, etc), then the mortgage interest would be deductible on Schedule E.  The money spent on the rental "could potentially" be deductible or capitalized depending on the improvement.

I don't understand how the government knows what you use the money for. What if I do a cash out refinance on my rental property and end up with $50K. I put that money in my rental bank account and don't spend it this year. I plan to use the cash in the future as a down payment for another rental property. It seems like I would still be able to claim all the interest. There is no place on my tax form to state what the money is used for or if it was even used. I have heard investors on BP podcast say they use cash-out money for vacations or other personal enjoyment. 

I know people who have done cash out refinances on their personal homes to pay off car loans, buy boats, etc. Mortgage lenders openly advocate this as a way to consolidate personal debt. 

@Joe Splitrock   The IRS would not know unless they audited you.  If they even look at that category of the audit.  

The terminology for this is called the tracing rules. The mortgage interest is suppose to follow what the money is used for. Now this can drastically depend on what type of entity you are. if you are a single member LLC or own the properties out right the tracing rules apply. If you spend your money on a car (personal) or a vacation or something personal it would be personal interest and non deductible. If you spend it on paying off student loans then it would be a student loan interest. If it was for investments then it would be investment interest. If you are in a partnership with partners then this calculation can become a bit more complex. It could be 100% deductible at the partnership level or it could follow the partner and it would have to be determined if its deductible or not at the partner level.

Yes the Mortgage lenders will advocate that, but they don't know the tax laws.  Now if they say it is deductible (general sense), they probably arent to far off, but it depends on the type of destructibility (Sch A, Sch E, Home office, etc).  However the mortgage interest is suppose to follow where the loan is intended for.  A lot of times this only matters on cash out refi (pulling cash to use somewhere else ) because your intending to use the money somewhere.  

Now everyone's situation is different and in many cases the details are a must.  So please contact your cpa or tax preparer with direct questions.  However a high level scenario is to follow the tracing rules.

@Erin K. Did you get a second opinion on the mortgage loan? I am not aware of a mortgage guideline that would prevent you from qualifying because your self employment income is too high. I would keep looking into the conventional mortgage loan options. PM me if your interested in more info regarding this.

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