Cash Out Refi and Interest Deduction

[msmith7305]

Client has following facts:

Principal Residence  

Cost $250,000    FMV $350,000

Outstanding Mortgage Balance with Lender A of $60,000 (Secured by Residence)

Second Home  

Cost $220,000    FMV $350,000

Outstanding Mortgage Balance with Lender B of $40,000 (Secured by Second Home)

Client decides to get a lower interest rate so they do a cash-out refinance on the Principal Residence for $100,000 with the current Lender A. They now have a $100,000 loan with that same lender and $40,000 cash in hand.

They then take the $40,000 cash and pay off the loan with Lender B on their second home.

I take the position that since the refinance excess cash of $40,000 was not used to "buy, build or substantially improve" the Primary Residence, the client will only be able to deduct the interest attributable to the outstanding balance of the original loan balance for that home.

In other words only 60% of the interest paid on the $100,000 note that remains will be deductible.

I think the client should have simply refinanced each home separately in order to preserve the deduction of interest on the full $100,000 balance.

Am I thinking right here? Can anyone point me to some regs or examples that deal with this specific issue?