TAX TALK: Refinancing for rental property deduction

By Judy O'Connor | Bankrate.com Published:

Dear Tax Talk,

One of my rental properties was bought with cash. There's no mortgage on it, so it generated profit each year to the IRS.

If I do a cash-out refinance, and those proceeds were used for another investment property (or to pay down my own primary residence), would I be able to deduct the interest on taxes? Anything I need to look out for? Thanks.

-- Sunny

Dear Sunny,

You'd like to refinance to get a rental property deduction. That's possible, but your losses may be limited.

The mortgage interest on your rental ­property will be deductible on Schedule E.

However, if the rental property goes from showing a profit as it does now to generating a net loss due to the interest deduction, your losses may be limited to passive losses. Let me explain.

Rental real estate activities are considered to be a "passive activity" by the IRS, and the general rule is that passive losses can be used to offset only "passive income."

There is an exception if you or your spouse actively participates in the real estate activity; then you may be able to deduct up to $25,000 of losses from your nonpassive income.

You should take a good look at IRS Form 8582, Passive Activity Loss Limitations, and see how it applies to your particular situation.

As far as paying down your home mortgage with the proceeds, you should check out interest rates for mortgages on the rental property.

You may find out the rates are higher than what you are currently paying on your home mortgage because the rental property is considered an investment property. Since I do not know what your current itemized deductions are, you should see what happens on Schedule A if you no longer have the home mortgage interest deduction.

If you use the money to acquire another rental property and it is generating passive income, then that income may be offset by any passive losses generated by your first rental property due to the mortgage interest deduction.

Thanks for the great question.

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