By If you refinanced a rental property and took cash out, or if you plan to do so, how you spend that money determines whether you can deduct the interest.
Tax law follows the money, not the property securing the loan.
If you use the refinancing cash for personal purposes, the interest on that portion is non-deductible personal interest even though your rental secures the loan. The part of the loan that replaced your original rental mortgage remains rental debt, and that interest stays deductible.
There is good news. IRS rules require that principal payments pay off the personal portion of a loan first. Every principal payment you have made after the refinance reduces the non-deductible portion before touching the rental portion.
Once you have repaid an amount equal to the personal cash-out, the entire remaining balance is rental debt again. If you refinanced in a prior year, you may have been deducting too little interest.
If you refinance in the future, take these steps:
- Deposit the proceeds in a new, separate account, and spend directly from it for the intended purpose.
- Avoid depositing loan proceeds into your existing checking account. Under IRS rules, the IRS treats any spending from that account as coming from the loan proceeds first, which can turn deductible interest into personal interest.
If you want to discuss refinancing a property, please call me on my direct line at 408-778-9651.