Using the Cash from Cash-out Refinance to pay off 2nd mortgage 2 years later

Forum|Forum|4 years ago
August 14, 2021
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My first mortgage has a $500K balance, and I also have a second mortgage of $250K, which has a 0% interest for two more years (this was part of my employer's relocation assistance). I am thinking of doing a Cash-Out refinance on my first mortgage and pulling out $250K cash (i.e., total refinance of $750K).

I know if I use the $250K cash proceeds to pay off the 2nd mortgage immediately upon refinance, then I can deduct the full interest on the refinanced $750K mortgage. However, I don't want to pay off the 2nd mortgage immediately because I still have 0% interest rate for two more years. If I keep $250K cash from Cash-out Refinance in a CD for two years, and then pay off the 2nd mortgage when it becomes due, can I still deduct the interest on the $250K portion of the refinanced mortgage? Maybe during the two years $250K is in a CD I can deduct mortgage interest on $250K as investment expense, and then after I pay off 2nd mortgage, I can fully deduct mortgage interest?

DanPaul02

I am sure you are aware that this is not a tax deductible use of the cash out from refinancing, but kudos for the effort.

si29xnmAuthor

I actually don’t know the answer. Based on the interest tracing rule, wouldn’t I be able to deduct mortgage interest as qualified residential home deduction once I pay off the second mortgage in two years?

DanPaul02

To qualify for a mortgage tax deduction the $25,000 must be used to improve the first home. Paying off another mortgage with the money makes the interest on the $25,000 not deductable.

Opus 17

Employee

Short answer: that's a really dumb idea. You are currently paying mortgage interest on $500,000 of total debt. Your plan would result in you paying interest on $750,000 of total debt. You have to invest that $250,000 to make way more money than CD rates to even approach the mortgage interest you will pay.

Firstly, the rules on mortgages over $750,000 don't work the way you seem to think they work.

If you follow the worksheet in publication 936, you will see that using the IRS method of calculating interest, you would have $1 million of outstanding loan balance, but only $750,000 of qualified acquisition debt. That means that only 75% of your mortgage interest is deductible. The worksheet does not allow you split out your loans separately and say you are deducting 100% of the interest on the 75% loan and none of the interest on the 25% loan (which is currently zero). What will happen is you will only be able to deduct 75% of the total loan interest you are paying.

https://www.irs.gov/pub/irs-pdf/p936.pdf

It is true that if you do eventually pay off the $250K loan, you would have $750K of qualified acquisition debt and $750K of outstanding loan balance so 100% of the interest would be deductible from that point.

It's also just a bad idea overall from a financial point of view. Let's think about this a minute.

First, you are borrowing $250,000 for 18 months at 3% (if you have excellent credit); that will cost you $11,250 that you currently don't need to pay.
Then, by making your mortgage only 75% tax deductible, you are giving up tax savings of $1850.
If you invest the $250K in a CD (0.8% APR) you will earn $3000, which is taxable, so you net $2340.

You're in the hole $10,760 compared to doing nothing and only refinancing when the interest-free period expires.

If you could get 6% on your investment, you would gross $22,500 in interest, net $17,500 after taxes, so the whole scheme nets you $4450 (which is probably still less than the closing costs on the cash-out re-fi). And if you could get 6% safely, and not lose value in your investment, in which case you are screwed.

The bottom line is that even in the highest tax bracket, the mortgage interest deduction does not make your mortgage free to you, it only reduces the effective interest rate by 1/3. If you re-fi at 3% and can fully deduct the interest, your effective interest rate is 2%. But if you take that cash and invest it somewhere else, you have to make way more than 2% to come out ahead, after figuring the tax impact of the lost interest deduction plus the income tax due on the investment income plus your closing costs. Can you make 6% or more without risking the money?

I would really suggest you sit pat, and then consider your options when the interest-free loan period expires.