Tax deductions after refinaning a rental property

[Rick Im]

I have two questions regarding mortgage interest tax deductions.

First, last year, I purchased a HUD property at a significant discount and used a $70,000 HELOC from my primary residence for the down payment. I understand that the interest on this HELOC should be tax-deductible, and I have documentation to support the transaction. Can you confirm if this is correct?

Second, I bought the property for $279,000, and its initial appraisal was $337,000. After completing renovations, the estimated appraised value has increased to $370,000. Now that the six-month seasoning period has ended, I'm considering refinancing the property. If I refinance for $279,000 and use $70,000 of the proceeds to pay off the HELOC, will the interest on the full $279,000 refinanced loan remain fully tax-deductible?

Rick

[Natalie Kolodij]

Hi Rick, 

First of all- congrats on diving in and your BRRRR deal going well!

Loan interest is deductible based on it's use-not the asset securing it. 

Since the HELOC was used for a business use (renovating the rental) you can deduct the loan interest against that rental using the interest tracing rules found in §1.163-10T.

The funds should be cleanly traced ideally. Meaning they went into a standalone bank account (not mixed with your other personal funds). 

When you refinance unfortunately all of the interest on that new loan will not be deductible. Again- loan deductibility is based on the use of funds, not the asset. So just because it's a loan on a rental property doesn't necessarily mean the interest will be deductible. 

There are types of deductible debt: 

- Acquisition debt (a loan to directly acquire an asset)

-Renovation loan (loan against an asset, used to renovate that asset)

-Replacement debt (a loan which is a refinanced replacement of an initial qualifying replacement). 

When you refinance- $70k of your new loan will qualify as replacement debt. (replacing the original HELOC debt)

However whether the interest for the  additional $200kish of loan  will be deductible will depend on 2 things: 

-How were the renovations paid for? If those were also initially funded with debt like a HELOC, then it would also qualify as replacement debt. 

- If you just personally paid for the renovations then the interest won't be deductible because "paying yourself back" doesn't qualify. 

And then there's any cash-out component. 

So if yo had $70k of initial purchase debt, for example spent $100k on renovations- and now you get a loan for $200k....$100k can potentially be deducted as replacement debt. 

But that extra $100k beyond that....depends on what you used those funds for. 

If you used them to purchase another rental/ use for another business endeavor...the process starts over. You can trace the interest to that business use. 

If you use the extra $100k of cash you receive to just...live on, buy a jetski, take a trip to Disney, (any personal use) the interest for that portion of the loan will not be deductible. 


Things like this are why it's important to work with a professional who is well versed in real estate taxation because the "common/simple" strategies taught frequently like BRRR or house hacking actually get fairly complicated when it comes to handling it correctly.