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Question
Three years ago, I refinanced my rental property, took out $60,000 of equity, and used the $60,000 for personal purposes. Since this loan is secured by my rental property, may I deduct the interest as rental property interest?
Answer
No. The interest on that $60,000 is personal interest, and you may not deduct it.
That is the whole of the usual answer, and it is where most write-ups stop.
Keep reading, though, because there is a rule buried in the same regulation that is probably already fixing this for you. You may be entitled to more deductions today than you think.
The Lien Is Almost Irrelevant
The law contains tracing rules that require you to follow the money to its use.
The regulation could not be blunter about collateral: Debt proceeds and the related interest are allocated solely by reference to the use of the proceeds. The allocation is not affected by the use of an interest in any property to secure repayment of the debt.¹
Here’s your situation in the IRS regulations: A taxpayer pledges investment stock as security for a loan and buys a personal automobile with the proceeds. The interest is personal interest even though investment property secures the debt.
So your mortgage is a mixed-use loan. The portion that carried over from the original rental debt stays allocated to the rental and produces rental interest. The $60,000 you pulled out and spent personally is a personal expenditure, and interest allocated to a personal expenditure is non-deductible personal interest.²
Each year, you split the interest between the two buckets in proportion to the debt allocated to each. Interest follows the debt allocation regardless of when you actually pay the interest.
Now the Mostly Overlooked Part: Principal Payments Kill the Personal Debt First
When you repay a debt that is allocated to more than one expenditure, you do not get to choose what you paid off, and neither does your lender. The regulation dictates the order, and it is stacked in your favor, as follows:
Amounts allocated to personal expenditures
Amounts allocated to investment expenditures and passive activity expenditures other than those in the next category
Amounts allocated to passive activity expenditures in connection with a rental real estate activity in which you actively participate
Amounts allocated to former passive activity expenditures
Amounts allocated to trade or business expenditures
Personal is first. This is not by election, and not by designation on your payment coupon—but by rule.
Every dollar of principal you have paid in the three years since the refinance has been eating the non-deductible $60,000 before it touches a penny of your deductible rental debt. If your amortization has knocked out, say, $14,000 of principal, your personal slice is down to $46,000, and your rental slice is untouched and fully intact.
Pull the payoff history, and recompute your allocation year by year. You may have been deducting too little.
And this is your fix going forward. Put $60,000 of principal against that loan, whether by amortization, a lump sum, or both, and the entire remaining balance is rental debt again with fully deductible interest.
Never Park Loan Proceeds in Your Personal Checking Account
This is where refinance proceeds should not go. Why? Because they become commingled with your personal funds.
If you deposit debt proceeds into a new checking or savings account, the IRS treats that bank account as an investment. There’s nothing to mingle with here.
If you deposit debt proceeds into an existing account, it’s also treated as an investment, but likely just for the moment of the deposit. Any expenditures, personal or otherwise, from that account are deemed made first from the debt proceeds.
Example. You have an existing checking account with $50,000 on hand. You deposit debt proceeds of $100,000 in the account. You pay household bills of $20,000. The IRS says that $20,000 was spent from the debt proceeds and that interest on that portion of the debt is personal interest.
Fifteen-day rule. You may ignore the ordering rules for expenditures made from an account within 15 days after the debt proceeds are deposited.
Key point. Make this easy: open a separate account for the debt proceeds, and spend directly from it for the intended purpose.
What If the Loan Had Been on Your Home Instead?
This is a fair question, because qualified residence interest is the one place where collateral does matter. Residence interest can qualify only if the debt is secured by the qualified residence. Your rental is not a qualified residence, so that route was never open to you.⁸
It would not have rescued you anyway. The One Big Beautiful Bill Act made the Tax Cuts and Jobs Act rules permanent. Home acquisition debt is capped at $750,000 ($375,000 if married, filing separately), with the $1 million grandfathered amount preserved for debt incurred on or before December 15, 2017.
And interest on home equity borrowing is deductible only to the extent you use the proceeds to add to or substantially improve the residence securing the loan, and only if it still fits inside the overall borrowing cap.⁹
Takeaways
Follow the money, not the lien. What secures the loan is nearly irrelevant to deductibility.
Refinancing a rental property and using some of the proceeds for personal purposes creates a mixed-use loan. Split the interest each year by the debt allocated to each use.
Principal payments retire the personal portion of the debt first, by IRS regulation.
Paying down the personal slice is the highest-value principal payment you can make.
Make your life easy. When refinancing, put the proceeds of the debt in a new checking or savings account. Commingling the refinanced proceeds in a personal account does nothing but cause trouble.
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