A cash-out refinance allows you to extract your home’s equity, or the difference between your current mortgage balance and the value of your home. You can then use it as a (relatively) low-interest loan to fund anything from home improvements or college tuition to medical bills.
Keep in mind, however: Cash-out refinancing might have tax implications in some scenarios.
Is a cash-out refinance taxable?
No, the proceeds from your cash-out refinance are not taxable. The money you receive from your cash-out refinance is essentially a loan you are taking out against your home’s equity. Loan proceeds from a HELOC, home equity loan, cash-out refinance and other types of loans are not considered income.
In addition to not paying income taxes, you might even be able to deduct some of the interest you pay on your cash-out refinance.
Tax rules for cash-out refinances
If you plan to itemize deductions, you can deduct the interest you pay on your new mortgage (the first $750,000 or first $375,000 if married and filing separately of indebtedness) from your taxable income. But you must use the cash-out funds to make what are known as “capital improvements” to your home.
Deduction-eligible projects generally include permanent additions and home improvements that increase the property’s value, extend its longevity or adapt it for new uses. Consider consulting with a tax professional to ensure the projects you’re doing qualify. It’s up to you to prove you used the money in a way that qualifies when you file your taxes, so save receipts and other paperwork associated with your projects.
“If you’re using that money to increase the value of your home and you get to write it off, it’s a double benefit,” says Ralph DiBugnara, vice president of Charlotte-based Cardinal Financial.
How to use your cash-out refinance so the interest is tax-deductible
Make capital home improvements
If you plan to itemize your deductions, the interest on your new mortgage might be a tax-deductible if you make home improvements such as:
Adding a swimming pool or hot tub to your backyard
Constructing a new bedroom or bathroom
Erecting a fence around your house
Enhancing your roof to make it more effective in protecting against the elements
Setting up a central air conditioning or heating system
Installing a home security system
Keep in mind that capital improvements are generally defined as permanent additions that increase the value of your home. Repairs like fixing a broken window or small design changes like painting a room don’t usually count.
“Capital improvements must substantially improve your home,” says Dennis Brager, a certified tax specialist with the Los Angeles-based Brager Tax Law Group. “Kitchen and bathroom remodels, room additions, modifications for an elderly parent would all qualify. A standalone painting would not qualify; on the other hand, if it was just part of a larger remodel, then the cost of the paint job would qualify.”
Add a home office
Another type of capital improvement: adding a home office. This could allow you to deduct the interest on your cash-out refinance. Plus, you can take the home office deduction if you’re self-employed or own a business. But you need to make sure you meet the requirements first.
To qualify for the home office deduction, taxpayers must “exclusively and regularly use the part of their home as their primary place of business,” according to the IRS. You must also itemize your deductions to take advantage of these benefits.
Improve your rental property
Improvements and repairs to rental properties are typically tax-deductible. A cash-out refinance does not affect repair expenses for a rental property, so you can still claim these deductions. You can use the funds from your cash-out refinance to do projects that let you increase the resale value of the home or the rent. You can also use the cash-out to make repairs to the property.
Deducting mortgage points on a cash-out refinance
Also called discount points, mortgage points are essentially upfront fees you pay a lender in return for a lower interest rate on your loan.
With a cash-out refinance, you cannot deduct the total amount of money you paid for points during the year you did the refinance, but you can take smaller deductions throughout the life of the loan. If you were to pay $2,000 in mortgage points on a 15-year cash-out refinance, for example, you can deduct about $133.33 per year for the duration of the loan.
Mortgage interest deduction limits with a cash-out refinance
You cannot deduct the interest on the entire new mortgage if you use the cash out for anything other than a capital improvement. That includes paying off credit card debt or buying a new car. In these cases, you’d only be able to deduct the interest on the original mortgage balance.
Let’s say you have a mortgage with a $60,000 principal, and you want to take out $20,000 in equity through a cash-out refinance. If you use the cash to add a hot tub to your backyard, you can deduct the interest you paid on the total balance, or $80,000. If you use it to pay off your credit card debt, you can only deduct the interest you paid on your original balance, or $60,000.
Even so, using a cash-out refinance to pay off credit card debt can still be a smart financial decision if you’re burdened by high-interest debt. Most credit cards charge double-digit interest rates, while mortgage interest rates are hovering around 6 to 7 percent.
In 2018, some of the deduction limits have changed. The simplified version of the current regulation: You can deduct interest on up to $375,000 worth of mortgage debt if you’re single or married filing separately, or on up to $750,000 worth of mortgage debt if you’re married filing together.
If you purchased your home before the new limits went into effect, you can still deduct interest payments on a higher balance, but that higher limit will not include any of your cashed-out funds.
Risks of a cash-out refinance
A cash-out refinance can be a cheap way to borrow much-needed cash, but it also means a new, larger loan you need to pay back.
“The biggest tax risk is that you fail to meet all of the stringent rules surrounding deductions, and you wind up with a big surprise at tax time,” says Brager.
“To avoid this, it is best to speak with your tax advisor about your personal circumstances before you make a commitment. The even bigger risk is not a tax risk, but that in tough economic times, you are unable to make payments on your mortgage, and you lose your home because you are overextended.”
Alternatives to a cash-out refinance
A cash-out refinance is not the only method of accessing equity in your home. Consider a home equity loan or a home equity line of credit (HELOC), which are second mortgages on your home. These options leave your current primary mortgage in place.
If you have a low interest rate on your existing mortgage, only taking out the amount you need may save you money now that interest rates have risen significantly.
Cash-out refinancing usually doesn’t have significant tax implications. The exception: when you use money to make capital improvements to your home. Be sure to consult with a tax professional to learn what might apply to your situation.