(Recasts with source saying Citgo auction has been canceled)

CARACAS/HOUSTON, Jan 20 (Reuters) - Venezuela has taken U.S. refining unit Citgo Petroleum Corp off the auction block and it will now seek to raise $2.5 billion in the debt market to provide funding for the cash-strapped country, a source familiar with the matter said on Tuesday.

The auction was canceled in the last 48 hours on the advice of Citgo's lawyers after they told Citgo that if the company wished to raise funds in the debt market, it should remove itself from the auction block, the source added.

Deutsche Bank has announced plans for a $1.5 billion bond to be issued by Citgo Holdings, with details expected to emerge next week, reported Thomson Reuters IFR earlier on Tuesday, without citing sources.

The German bank has also scheduled bank meetings for Thursday in New York to launch a $1 billion senior secured first lien five-year term loan B, according to IFR.

Citgo and Venezuela's state-run PDVSA declined to comment.

The Wall Street Journal first reported that the Citgo auction had been canceled.

Citgo's assets, including a refining network with capacity to process up to 750,000 barrels per day (bpd) of crude, have been up sale since 2014. Several bidding rounds have been held by banking firm Lazard Ltd, hired by PDVSA to manage the operation.

Although Venezuela's finance minister in October denied the pending sale, Lazard had continued with the process in recent months, according to sources close to the deal.

Offers from at least four bidders were received as of mid-December, some of which valued the company at more than $10 billion, three people familiar with the matter told Reuters in December.

The companies that made bids included Marathon Petroleum Corp, Valero Energy Corp, HollyFrontier Corp and a consortium of TPG Capital LP and Riverstone Holdings LLC.

Citgo announced in mid-2014 that it had finished a refinancing operation to reduce interest payments, which improved its credit profile. But agency Moody's downgraded PDVSA and Citgo's rating last week due to a higher probability of default.

Venezuelan bonds have tumbled in recent month as investors worry it could struggle to make sizeable debt payments amid tumbling oil prices and slipping international reserves.

President Nicolas Maduro says the country will honor all its debt payments and dismisses debt default as a right-wing smear campaign.

(Reporting by Brian Ellsworth in Caracas, Marianna Parraga in Houston and Mike Stone in New York; Additional reporting by Sneha Banerjee and Sai Sachin R in Bengaluru; Editing by Marguerita Choy and Lisa Shumaker)