In a cash-out refinance (US) can I deduct interest on the original equity + 100K or just 100K?

Question

I have looked at dozens of sites describing the US tax rules for a deducting cash-out refinance interest and I find they are all slightly ambiguous in their wording. All of those sites point out that only interest on the first 100K of the cash-out can be claimed as a mortgage interest deduction, but it is unclear if that amount excludes, includes or is in addition to the original principal amount that was paid off.

Say I have a current mortgage with 50K unpaid principal. I want to do a cash-out refinance to cover the original mortgage plus 200K, for a total new mortgage of 250K (assume the home value is high enough that LTV ratio is acceptable to the lender).

Is the interest I can claim as a deduction on just 100K total, or is it on 50K (original mortgage) + 100K (of the cash out) = 150K?

Subtly different question -- what if the extra cash-out is 50K, for a total new mortgage of 100K? I assume the interest deduction would be 100K and not 50K, but do correct me if I am wrong there.

Answer 1

The short answer: Original equity plus 100k, up to the fair market value of the home.

You have two considerations when considering the deductability of the interest of a refinanced mortgage.

First off, you can count interest on the principal that was used to acquire the home, plus any amount spent on improving the home (document this, though).

Secondly, you can count up to $100k (married, filing jointly) of home equity debt towards your maximum limit. This is a separate amount, not included in the first amount (the original equity), so it is additive.

However, you are restricted to the lesser of $100k, or the total fair market value of the home minus the amount considered in the first category (acquisition/improvement), when considering both together. The IRS explains this in publication 936:

Example. You own one home that you bought in 2001. Its FMV now is $110,000, and the current balance on your original mortgage (home acquisition debt) is $95,000. Bank M offers you a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or other liens. To consolidate some of your other debts, you take out a $42,500 home mortgage loan [(125% × $110,000) − $95,000] with Bank M.

Your home equity debt is limited to $15,000. This is the smaller of:

• $100,000, the maximum limit, or
• $15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000.

So if your cash-out refinance allowed you to borrow more than the fair market value of the home, only deduct interest on principal up to that amount. The appraisal you presumably paid for during the refinance process will cover this.