You take a cash-out refinance on your rental property. The loan is secured by a rental, so the interest is 100% deductible, right? Wrong. 🛑
In the eyes of the IRS, your mortgage interest deduction is NOT determined by which property secures the loan—it is determined by what you spend the money on.
In this video, Stephen Morris breaks down Treasury Regulation 1.163-8T (The Interest Tracing Rules). We explain why using rental equity to buy a boat kills your deduction, while using it to buy stocks or another property saves it. Plus, we cover the dangerous “Commingling Trap” that ruins deductions for even the smartest investors.
In this video, we cover: đź’¸ The “Use” Test: Why collateral doesn’t matter, but “use of funds” does. 📉 The 4 Scenarios: How taxes change if you spend the cash on Groceries, Stocks, Renovation, or a New Property. ⚠️ The Commingling Trap: Why depositing loan proceeds into your personal checking account is a fatal mistake. 🗓️ The 30-Day Rule: The IRS “safe harbor” that can save your deduction.
TRANSCRIPT:
Hello everybody, Stephen Morris here at Advise RE. And you know what we love to talk about here? Real estate, taxes, and of course real estate taxes. So let’s jump into it. Let’s talk about a specific area around mortgage interest deductions and how we always know that mortgage interest is always deductible as it relates to your rental properties—except when it isn’t. So when is it not going to be deductible? Let’s talk about that.
Picture this: you have a rental property and after a few years of successfully collecting rents and increasing the value of the property, you eventually go out to one of the lenders and the lender offers you an additional $100,000 in cash-out refinancing, which you can use to literally do anything you feel like in the whole world. You can take the $100,000 and go to Las Vegas and bet it all on black and hope you win. You can go out and buy a brand new car or you can use it towards an additional property. Let’s talk about what happens when you use these proceeds and what the tax outcome would be as it relates to what you use those proceeds for.
The reason why we want to know what you’re using those proceeds for is because under the tax rules, the IRS is looking for where you’re going to use those funds, and the interest that relates to those funds is going to be either deductible or not deductible depending on the circumstance. Under Treasury Regulation 1.163-8T, the rules state that where the funds flow to—what they’re used for—will determine the deductibility of the interest that you have based on the refinance. Let’s go through a few examples to illustrate how this will work out.
Example A: The $100,000 arrives in your bank account, you immediately spend it on groceries and food and all sorts of other cool personal stuff. In this scenario, even though the mortgage is secured by the property which you took a refinance on, the interest expense corresponding to that refinance is not going to be deductible because you use that money for personal expenses. We know in the tax world that personal costs are almost entirely never deductible for business purposes.
Scenario B: You take the money out and you use it to buy a bunch of stocks. You buy some really cool AI stocks, you buy some REITs, maybe you buy a few other tech stocks. That’s fine, it will be deductible but in the form of investment interest. Investment interest expense has limitations and those rules will be played out kind of in the itemized deduction territory. So that expense will be deductible as an itemized deduction.
Scenario C: You take the money out and you use it to reinvest in the property that you took the refinance on. You went ahead and upgraded the electrical or created the plumbing. No problem, all that interest is deductible as an expense towards a rental property under Schedule E or, if you have a partnership return, under 8825.
Scenario D: You take that money out and you invest it in another property. Sounds good, the interest expense relating to the refinance is going to be deductible on that other property, not the property which the mortgage originated from.
So where do folks get caught? What ends up happening is they receive the loan proceeds and they don’t quite get to what they plan to invest in quite yet. The $100,000 lands in their personal bank account and then they go out and spend it on all sorts of cool stuff like groceries or whatever and they totally jeopardize the ability to deduct that interest expense because they use those proceeds for something other than an investment purpose.
The better way to do it is to have that money and place it into a separate bank account. If you plan to invest it later on, then you can use the funds from that separate bank account to go ahead and take care of some sort of investment activity. Also, the IRS respects a 30-day rule. So within 30 days if you can use those funds towards whatever you plan to do with it—buy another property or buy stocks and bonds—then they’ll allow that and you’ll be able to allow you to trace the interest to that particular activity which will allow you to take that deduction for mortgage interest.
The most important thing that I recommend to all of you, however, is that when you are doing a refinance and you plan to use those proceeds for an activity other than with the refinance related to that, you have very strong documentation. Number one, make sure that you have written documentation stating “I’m using this money for this activity. I’m sending the money over here.” Use memos or notes within your bank transfer statements as well. You can typically type in notes whenever you’re doing a transfer. That will greatly support you as well when you’re doing that online.
And also just on top of that, you want to have a general sort of control over where those funds go to. You don’t want there to be this long lag or delay between the money that you receive and the investment activity that you plan to invest in.
So I just want to give you a quick little tip here to help you out with understanding the way mortgage proceeds work. And also I want to kind of dispel the illusion that just because the mortgage is secured by a property doesn’t mean that it’s always deductible. Okay, so sometimes the refinance proceeds can be non-deductible depending on its use. Just wanted to be aware of that. If you have any questions at all about this or if you have some sort of issue that you’d like to talk about as it relates to your next refinance, then please feel free to reach out to us here and we’ll be more than happy to assist you.
Thanks so much for watching. Make sure to like and subscribe to our channel for all the content relating to real estate investment and tax saving strategies.
