Can an individual take money out of their primary residence either by refinance or a second mortgage to purchase a second home?

Here is the problem in a nutshell, and one that everyone overlooks. Home (and second home) acquisition debt must be secured by the home.

Any money borrowed against the primary home, if not used to acquire or substantially improve the primary home, would be equity debt and the interest on equity debt is not deductible.

However, the tracing rules allow us to trace the use of the equity debt funds, which was to purchase the second home. Here is where the bad news comes in - the debt is not secured against the second home. So, the interest is not deductible as second home mortgage interest, and unfortunately not deductible at all.

Combining the provisions of the interest tracing rules and the provisions of construction or substantial improvements and tracing the equity debt on the primary residence and using the 90-day rule to replace the equity debt may allow interest to be deductible.

Notwithstanding the tracing rules of Reg § 1.163- 8T, in the case of the acquisition of a residence, debt may be treated as incurred to acquire the residence to the extent of expenditures to acquire the residence made within 90 days before or after the date that the debt is incurred.

In the case of the construction or substantial improvement of a residence, debt incurred prior to the time the residence or improvement is complete may be treated as being incurred to construct or improve the residence to the extent of any expenditures to construct or improve the residence which are made no more than 24 months prior to the date that the debt is incurred. Debt incurred after the residence or improvement is complete, but no later than the date 90 days after such date, may be treated as being incurred to construct or improve the residence to the extent of any expenditures to construct or improve the residence which are made within the period beginning 24 months prior to the date the residence or improvement is complete and ending on the date the debt is incurred.

For purposes of determining whether debt is incurred to acquire, construct, or substantially improve a residence, debt is incurred on the date that the loan proceeds are disbursed to or for the benefit of the taxpayer (i.e., generally the loan closing date). The taxpayer, however, may treat the debt as being incurred on the date that a written application is made to incur the debt, but only to the extent that the debt proceeds are disbursed within a reasonable time after approval of the application. Debt proceeds disbursed within thirty days after approval of the application are considered disbursed within a reasonable time after approval of the application. Regulations will provide that if a written application is made for a debt within the requisite time and the application is rejected, a reasonable additional time will be allowed to make a new application for such debt. The rule that a taxpayer may treat debt as being incurred on the date that a written application is made to incur the debt does not apply, however, for purposes of determining if debt is pre-October 13, 1987 indebtedness. (Notice 88-74)