Refinancing home opens opportunities

3 min read

Dear Tax Talk,
My wife and I are looking to buy a vacation home primarily to be used as a rental property. We have applied for an 80 percent LTV (loan-to-value) cash-out refinance on our primary home, valued at $360,000. The original amount borrowed was $165,000. The balance is $100,000. I wish to pay off $40,000 in unsecured debt, pay the balance of the existing loan, then use the remainder (after about $8,000 in closing costs) to make an offer on a vacation home.

I was under the impression that all of the interest for the new loan would be tax deductible. After reading an IRS publication, I think I was mistaken. Is there a limit to the amount of interest that can be deducted? What would be the best way to finance my objectives to maximize tax advantages?

The lender I put a $500 deposit with advised against two loans (one a cash-out to cover my debt and a down payment on the vacation home, the other a loan to cover the balance of the vacation home offer). I was concerned about the deductibility of the interest in one loan, but the lender told me the interest would be deductible on the single loan. Now I’m not so sure.
— Matthew

Dear Matthew,
All of the new borrowing should qualify for deduction.

In tax terms, there is home acquisition debt, home equity debt and other borrowings. Home acquisition debt is debt incurred to purchase or substantially improve a first or second home. Interest on up to $1 million in acquisition debt is deductible. When acquisition debt is refinanced, only the balance immediately prior to the refinance is considered acquisition debt. In your case, only $100,000 of the $288,000 (80 percent of $360,000 value) in the new loan will be considered home acquisition debt.

A homeowner can also deduct the interest on up to $100,000 in home equity debt borrowed for any reason, such as consolidating unsecured debt. You are using $48,000 of the $100,000 ceiling for any purpose so that when added to the home acquisition debt, 148,000 divided by 288,000 (or 51.39 percent) of the interest paid on the new debt will be deductible on Schedule A. You can also get a deduction on Schedule A as high as $200,000/$288,000 (69.44 percent) of the interest paid using the $100,000 acquisition debt and the $100,000 equity debt.

For your situation, your remaining cash is $140,000 which you plan to use to buy a vacation/rental home. If the property qualifies as a second home then all the interest paid on the $288,000 loan will be deductible on Schedule A. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to qualify as a second home. You must use this home more than 14 days or more than 10 percent of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home.

If the property is considered a rental property, then the allocable interest of the new debt would still be deductible. However, it would be reported on Schedule E together with the other expenses of the rental property. The allocable interest could be as little as $88,000/$288,000 or as much as $140,000/$288,000 since you have the flexibility of counting $52,000 more of the debt as home equity debt, as discussed above.

The lender is right in that the interest is deductible on the single loan and there is no need to take out two loans.

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