Tax Deductible Uses for Extra Funds from Cash Out Refi

Tax, SDIRAs & Cost Segregation
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Tax Deductible Uses for Extra Funds from Cash Out Refi

Will Johnston
Investor · Washington, DC · Member since 2014 · 107 posts · 25 votes

I recently did a cash out refi on an investment property to pay off the line of credit I had used for the downpayment on said property.

I have about $5k in funds left over, and I'm trying to figure out what to do with them so that the whole amount of interest on my mortgage on the investment prop remains tax deductible.  Here are the possible scenarios I'm considering.

  • Pay down the principal on the investment prop.  Of course, if I wanted to do that, I would have just taken out a smaller loan with smaller payments to start.
  • Use it to pay down the remaining balance on my line of credit, which was used for the down payment on my primary.  I'm assuming if I do this I can continue to deduct the interest, although I'd have to actually separate out how much of the loan is for the investment prop (98.5ish%) and how much is for my primary residence (1.5ish%).
  • Use it to pay ahead on the mortgage on the investment property.  Would this actually be a tax deductible use?
  • Buy another investment property.  But I don't have the time to facilitate that purchase at the moment, so I would just have the cash sitting around in an account bearing 1% interest for six months until I'm ready to buy my next door.

Other ideas?  I don't have any capex on the property at the moment, although that's not to say there won't be in 2-3 years.

Thanks!
Will

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  • Brie SchmidtBusiness Member
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    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
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    @Will Johnston - You write off 100% of the interest on your Schedule E, regardless of what you do with the funds you got from the cash out refi.  

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  • Account Closed
    Investor · Wilmington, NC · Member since 2016 · 80 posts · 43 votes
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    @Will Johnston, I had the same question and would be interested in hearing from a CPA or accountant on this topic.

    I assume you'd like to use the funds such that you can correctly deduct all the interest on Schedule E, for that particular property, while abiding IRS rules.

    I believe paying down any debt used the purchase or rehab the property should qualify if done correctly. I believe if you use the funds for something other than expenses for that particular property, they are not deductible on schedule E for that property. (If you invest the funds elsewhere, they might be deductible elsewhere but not on schedule E for that property)    


    My thought was to deposit the funds directly into a segregated account and then use the funds to pay any and every qualifying expense associated with the property until the account is depleted - possibly including loan payments, taxes, insurance, utilities, management. Income from the property I'd just deposit into a regular account, and keep out of the segregated account. I'm not sure if there's a problem with that approach and would like to hear other opinions. 

    @Brie Schmidt: I'm not a CPA, but I've done my own taxes for years now. My reading of the IRS publications for Schedule E & interest deduction indicates that it's not correct to deduct 100% regardless of how you use the funds. IRS specifically states how you use the funds matters. 

    IRS instructions for Schedule E, lines 12 and 13 states: 

    In most cases, to determine the interest expense allocable to your rental activities, you must have records to show how the proceeds of each debt were used. Specific tracing rules apply for allocating debt proceeds and repayment. See Pub. 535 for details.

    IRS Publication 535 states:

    The rules for deducting interest vary, depending

    on whether the loan proceeds are used for business,

    personal, or investment activities. If you

    use the proceeds of a loan for more than one

    type of expense, you must allocate the interest

    based on the use of the loan's proceeds.

    To keep accounting, bookkeeping, and taxes as tidy & simple as possible, we want to keep the borrowed funds associated with the property, keeping funds segregated if possible, being conscience of IRS tracing rules.

    I hope that helps. I'd like to hear more knowledgeable comments on this topic.

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  • Brandon Hall
    CPA · Raleigh, NC · Member since 2013 · 1k+ posts · 2k+ votes
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    @Brie Schmidt can't deduct 100%, @Account Closed the interest on your excess funds ($5k) is the portion of the debt that will not be deductible under the tracing rules. Assuming a rate of 4.5%, we're talking about potentially missing out on a $225 deduction. Because of this, I wouldn't use a tax deduction as the motivator to applying the capital.

    Most often, people will roll the funds into another property or back into the property the debt applies to via capital improvements. If you can't do either, then perhaps look at improving your primary residence. An election can be made to move the $5k and the associated interest over to Sch A so you won't "lose" the decision in that manner.

    But if you can't find a way to apply the capital in a feasible manner, don't make a hasty decision simply for a $225 write off.

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  • Account Closed
    Investor · Wilmington, NC · Member since 2016 · 80 posts · 43 votes
    10y

    @Brandon Hall, if the excess funds were deposited in a segregated account, and then used to pay ongoing expenses for the property, or later capital improvements on the property, would it then be correct to deduct the interest on schedule E for the property?
    If so, are there any expenses that wouldn't qualify? mortgage or loan payments for example? is there a time limit for using the funds? For example if the funds were earmarked for improvements next time it was vacant?
    Thanks!

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  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    10y

    @Account Closed,

    As I understand the IRS tracing rules, depositing the funds for future use does not make the interest on those funds deductible on schedule E until the funds have been spent on the Schedule E property.

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  • Brie SchmidtBusiness Member
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    Real Estate Broker · Chicago, IL · Member since 2013 · 6k+ posts · 5k+ votes
    10y

    Interesting, I had no idea.  I never did a cash out refi on an investment property so I didn't think it mattered. 

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