With home prices rising significantly the last year, many homeowners are refinancing and increasing their mortgage. The interest expense deduction from these cash out refinancings can be complex. Interest expense is traced to the usage of the proceeds and is not tied to how the debt was collateralized. Below is a discussion of some common uses of proceeds and how that could impact the treatment of the interest expense deduction
Payoff of Personal Debt or the Purchase of Personal Property
If you use the proceeds to pay off personal debt the interest expense would not be deductible. This would include paying off credit cards, auto loans. This would apply if you used the proceeds to buy personal property such as autos, boats, jewelry or other personal items.
Purchase of Rental Properties
If you use the proceeds to purchase or improve a rental property that interest would be deductible as an expense against the rental property revenues on your Schedule E. This deduction could be subject to other limitations.
Home Improvements
If the use of proceeds is used to make home improvements such as remodeling or additions such as adding a pool, then the interest would be traced to your home mortgage deduction. This means it would be an itemized deduction on Schedule A assuming you are itemizing deductions and not using the standard deduction.
What if I Later Redeploy the Cash?
The classification of the interest expense continues to follow the proceeds and thus can change over time. If you borrowed on your home to purchase a rental property but then later sold that property and bought a car then the interest would no longer be deductible since the proceeds would later be recharacterized and traced to the purchase of personal property.