A Guide To The Tax Implications Of A Cash-Out Refinance
Victoria Araj7-minute read
May 12, 2021
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Do you have equity in your home? Equity is the amount of your property that’s truly yours because you’ve paid off or earned that portion of it. You might want to use your equity to your advantage, such as getting a cash-out refinance to cover some more expensive debt.
We’ll take a look at some of the implications you’ll need to consider when you file your taxes during the year you take a cash-out refinance. We’ll give you a refresher on how these refinances work so you can understand how the IRS views the money you receive. Finally, we’ll show you how you can use the money you get from a cash-out refinance for tax-deductible purposes.
Overview: Tax Implications And Mortgages
You accept a loan with a higher principal and take out the difference in cash when you take a cash-out refinance. The IRS views refinances a bit differently compared to when you take out your first mortgage. In other words, the IRS sees refinances as a type of debt restructuring. This means that the deductions and credits you can claim with a refinance are less robust than when you originally took out your loan.
The new Tax Cuts and Jobs Act of 2017 increased the standard deduction for both single and married filers but also cut many of the deductions homeowners could previously count on.
Under the new tax law, your insurance payments aren’t considered tax deductible. Some new rules also apply to refinances in particular. For example, you cannot deduct the total cost of any discount points you pay at closing the year you get your new loan. However, you may deduct them over the course of your new loan.
How Do Tax Laws Affect Cash-Out Refinances?
It’s important that we go over exactly how cash-out refinances work before we look at how the IRS views the money you get from this transaction. Basically, you replace your existing mortgage with a loan that has a higher principal balance. Your lender then gives you the difference in cash. You can use the money from a cash-out refinance for almost anything. Many homeowners use it to consolidate debt or make home improvements.
Let’s look at an example. Say you have $100,000 left on your mortgage loan and you want to do $30,000 worth of repairs. Your lender might offer a new loan worth $130,000 at 4% APR. You take the refinance and your lender gives you $30,000 in cash a few days after closing. You then pay back your new mortgage loan over time, just like your old loan.
One of the first questions that homeowners have when they take a cash-out refinance is whether they need to report it as income when they file their taxes.
As you can see, the cash you get from this kind of refinance isn’t “free money.” It’s a form of debt that you must pay interest on over time. The IRS doesn’t view the money you take from a cash-out refinance as income – instead, it’s considered an additional loan. You don’t need to include the cash from your refinance as income when you file your taxes.
In exchange for this leniency, there are a few rules on what you can and cannot deduct when you take a cash-out refinance. Though you can use the money for nearly anything, you’ll need to use it for a capital home improvement in order to deduct your interest. IRS Publication 936 covers this in a little more detail. As a general rule, you need to make some kind of improvement to your home that increases the property’s value to deduct your interest. You usually can’t deduct the interest if you use the money for anything else, like paying off credit card debt or taking your dream vacation.
Ways To Use Your Cash-Out Refinance So It’s Tax-Deductible
There are limitations on what interest you can deduct when you take a cash-out refinance and there are a few ways you can use the money from your refinance that are tax-deductible. Let’s go over a few of them now.
Capital Home Improvements
You can deduct the interest you pay on the portion of your loan that you refinance if you make a capital improvement in your home. Anything that adds longevity to your home, increases its value or adapts the home to a different market counts as a capital improvement. Some of the most common capital improvements include:
- Adding a swimming pool, spa or jacuzzi to your backyard
- Putting in a fence for privacy or aesthetic reasons
- Incorporating a new bedroom or addition to your home
- Fixing your roof to make it more durable
Capital improvements aren’t limited to big-ticket items. Here are a few smaller improvements:
- Adding a central air-conditioning system or heating system
- Replacing your existing windows with storm windows if you live in a storm-heavy area
- Installing a home security system
Remember that only additions count as capital improvements. Home repairs don’t improve the baseline value of your property and don’t qualify for an interest deduction. Some home repairs that don’t qualify for an interest deduction include:
- Fixing an HVAC system
- Replacing a broken window
- Painting a bedroom
Improving the value of your property means you can also save money when you sell your home. Capital home improvements count toward the total amount you spent on the property and can potentially lessen your capital gains tax liability. Remember to keep careful records and receipts so you know when you did your renovations and how much money you spent.
Adding A Home Office
Adding a home office is a capital improvement and allows you to deduct the cost of any interest you pay toward your cash-out refinance. A home office can also offer additional tax benefits if you’re a small-business owner or are self-employed.
You can claim the home office deduction on your federal taxes when you add a home office to your residence. The home office deduction allows you to claim a percentage of what you pay in your mortgage as a business expense. You may choose the simplified deduction or the regular deduction when you calculate your tax liability.
- You can deduct $5 per square foot from your federal taxes when you take the simplified option if your home office is less than or equal to 300 square feet.
- You need to take the regular deduction if your home office is larger than 300 square feet. The regular deduction gives you a deduction based on your office’s size as it relates to the overall cost of your mortgage.
Let’s look at an example. Imagine that you add a 500-square-foot home office to your primary residence. This brings your total property size to 2,000 square feet. Let’s also imagine that you pay $700 a month for your monthly mortgage payment. Let’s say you own a small business and conduct your business primarily from the office you’ve added. You can deduct 10% of your monthly mortgage payment ($840 annually) from your federal taxes as a business deduction.
Keep in mind that not everyone who adds a home office can claim the home office deduction. You must meet some specific criteria to qualify for this deduction:
- Regular and exclusive usage: You must only use your home office for business purposes, and only you and your clients can use your office space. You cannot claim the home office deduction if you add a home office but it also doubles as a guest bedroom or a child’s playroom.
- Principal place of business: Your home office must be the primary place that you conduct business. Though you don’t need to only conduct business from your office, it must be the place where you do most of your work, billing or accounting.
Any Improvements Made To A Rental Property
You might use the money from a cash-out refinance to improve or repair a rental property and can deduct these expenses from your federal taxes. Any improvements or repairs you make to a property you rent out are almost always tax deductible. This is because the IRS considers any money you earn from rent as personal income. You can also deduct closing costs, interest and insurance you pay on a rental property from your income as business expenses.
Can You Deduct Your Mortgage Points?
Your mortgage lender might allow you to buy discount points. Discount points allow you to pay money up front to “buy down” your interest rate. Though these points are deductible, you cannot deduct the full amount you pay the year you refinance. Instead, you must spread the cost over the total course of your loan.
For example, let’s say that your lender allows you to purchase $1,500 worth of discount points on a 15-year refinance. You would be able to deduct $100 worth of discount points from your taxes for each year that you hold your loan.
The Bottom Line
The cash you take out of your equity during a refinance isn’t considered income by the IRS. However, there are limitations on refinancing deductions that you can take when you refinance your loan. You may only discount interest you pay on your new loan if you use your cash to make a capital improvement on your property. You may be able to take advantage of additional deductions if you’re self-employed or use the money to improve a rental property. You can also deduct your interest discount points over the course of your loan.
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