Dear Tax Talk,
My primary residence is paid off. I took a cash-out refinance on this property so I can make a cash offer on a second home (rental property). I was told I can write off all the interest on this new loan if I can show a "trace" from the cash-out refi to the rental property. That would show the money is used for "acquisition debt." My question is this: I am having trouble finding a rental I want, so how soon must I purchase a rental in order to use that write-off? Is there a time frame in which I must use that cash-out money to purchase the rental before it is no longer considered acquisition debt? What are the tracing rules?
The term "acquisition debt" relates to debt incurred to purchase your primary or secondary personal residence (not rental). When you borrow money to purchase something other than your home, you have to use the tracing rules. There's not necessarily any time limit to tracing the refi proceeds to the purchase of the rental property. However, if significant time elapses and your refi proceeds are commingled with other funds and you have other borrowings, the tracing becomes more complex.
To make it less susceptible to questioning, you should segregate the refi proceeds into a separate account. If you hold the money there and don't take on additional debts, then when you use the proceeds, the entire amount could be allocated to the rental activity. In the interim, the interest incurred would be considered investment interest.
Alternatively, you could elect to treat up to $100,000 of the refi debt as home mortgage debt and deduct the interest on Schedule A. You could do this even if you later use the proceeds to acquire a rental property. In fact, this may make more sense if you're running into loss limitations on the rental property.
For example, if you cashed out $150,000 and bought the rental property for that price, you could treat part of the interest as expense against the rental property and part on Schedule A. You could treat up to two-thirds of the debt as primary home interest ($100,000 out of $150,000) and the balance as rental property expense.
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