A guide to the tax implications of a cash-out refinance

Cash-out refinancing lets you replace your mortgage with a new one while turning some of your home equity into cash you can use as you wish. Generally, you don’t have to pay tax when you get a cash-out refinance, but there may be situations where you can deduct some of the interest you pay on the new loan.

Understanding how that tax deduction works and how you can qualify for it will help you decide whether a cash-out refinance is right for your situation.

The tax implications of refinances

The tax code contains many different tax credits and tax deductions for homeowners that let you reduce your taxable income. One deduction is the home mortgage interest deduction, which allows you to deduct some or all of the interest you pay on your mortgage.

To take advantage of the deduction, you must meet these requirements:

• The mortgage must be on your primary or secondary residence.
• You must itemize your deductions rather than use the standard deduction.
• Interest on the loan must be included on Form 1098.

Rules for cash-out refinance mortgages are slightly different. If you refinance, you can only deduct the interest paid on the amount of the loan up to the principal balance or the loan you had just before refinancing. That means that the interest on the portion you cashed out usually cannot be deducted.

However, if you use the cashed-out portion of the refinance to buy, build, or substantially improve your home, you can deduct the interest on that portion.

Put simply, cash-out refinancing to access home equity doesn’t increase the amount of your mortgage interest deduction unless you use the proceeds to make home improvements.

Tax implications of refinancing rental properties

Tax deductions for residences and rental properties are quite different, so if you’re refinancing a rental home, it’s important to be aware of those differences.

For example, with rental properties, you can deduct mortgage interest as well as other ordinary expenses related to maintaining your rental property, which is not something you can deduct for a primary residence.

Generally, all of the costs related to your rental property are considered business expenses, which makes them deductible. That means you can deduct the full amount of interest paid, plus other loan costs like origination fees or points, even after you do a cash-out refinance.

Always check with a tax professional to make sure these tax deductions are current, as tax codes can change.

Is a cash-out refinance taxable?

No. The money you borrow with a cash-out refinance is not taxable. You don’t have to pay income tax on it. However, you can’t always take advantage of the same tax deductions that you can when you get a mortgage to buy a home. To qualify for those deductions, you’ll need to use the cashed-out portion of the loan for home improvements. Again, check with a tax professional to find out more about how to use these deductions and what kind of records you need to keep to do so.

Filing taxes with a cash-out refinance

When you get a cash-out refinance, you’re replacing an existing mortgage with a new one for a higher amount, pocketing the difference in cash that you can use for other purposes.

For example, if you have a $200,000 mortgage loan and get a cash-out refinancing loan for $250,000, you now have a $250,000 mortgage but also have $50,000 in cash.

Because you borrowed the money, the IRS does not consider that $50,000 in cash that you now have available to be income. Instead, it’s money you financed using your new loan, so you don’t need to report it as income when filing your taxes.

You must meet specific requirements to deduct your interest

In the above example, you replaced a $200,000 loan with a $250,000 loan. Typically, in this scenario, you’d only be able to deduct interest paid on the first $200,000 of the loan when using the home interest deduction.

However, in some cases, you may be eligible to deduct interest on the full amount of the loan. In general, your eligibility depends on how you use the loan proceeds. Specifically, if you use the money to substantially improve the home, you may be eligible for deductions on the full amount of the loan.

Improvements must do one of the following to qualify as substantial:

• Add to the value of your home
• Prolong your home’s useful life
• Adapt your home for new uses
• Things that could add to the value of your home include:
• Increasing the home’s square footage
• Remodeling a kitchen or bathroom
• Adding a deck or patio
• Building a garage
• Finishing your basement

Tax law can be complicated. While you can review IRS Publication 936 yourself, it’s best to work with a tax professional to make sure you understand whether your cash-out refinance will be deductible or not.

How to make your cash-out refinance tax-deductible

If you’re planning on a cash-out refinance and want to make sure you can claim mortgage refinance deductions on your taxes, use these tips:

• Make capital improvements to your home
• Add a home office or expand your property
• Improve rental properties
• Always keep records and receipts, and consult a tax professional

Make capital home improvements

One way to make sure the interest on your cash-out refinance is tax-deductible is to make sure that the improvements you make are what the IRS considers to be capital improvements. These are things that increase the value and utility of your home, such as:

• Installing a swimming pool or hot tub in your backyard
• Building a fence
• Making additions to your home, such as a bedroom or bathroom
• Fixing or upgrading your roof
• Replacing or upgrading central air conditioning and heating systems
• Installing energy-efficient appliances and windows
• Adding home security systems

Repairs that don’t qualify for deductions

Keep in mind that you can only deduct the interest if you make capital improvements to your home. Some things are not capital improvements and don’t qualify for deductions.

Some things that don’t qualify for deductions include:

• Costs or maintenance that are necessary to keep the home in good condition but that don’t improve its value or prolong its life, such as:
• Painting
• Fixing leaks
• Filling holes or cracks
• Replacing broken or damaged hardware
• Costs of improvements with a life expectancy of less than one year
• Costs for improvements that are no longer part of the home, such as carpeting that was installed and later replaced

An exception to this is that you may deduct costs if repairs are done as part of an extensive restoration or remodel of your home. This is good news for real estate investors, because they can take a deduction for these types of repairs so long as they’re doing an extensive remodel.

Add a home office

Adding a home office gives your home additional utility by letting you operate a small business or work as a self-employed individual out of your home.

Not only does this increase the value of your home, letting you deduct the interest on your cash-out refinance, but it also may make you eligible for the home office deduction, which lets you take additional deductions for things like insurance, utilities, and maintenance.

To qualify as a home office, the space you add is used:

• Exclusively and regularly used for your business
• As your principal place of business, to regularly meet with customers, or it must be a separate structure

How home offices are deducted from your taxes

If you qualify for the home office deduction, you can choose one of two methods for calculating the deduction:

• The regular method involves calculating the direct expenses of your office, such as repairs and painting, and indirect costs, such as the proportion of mortgage interest, property taxes, and utility costs paid based on the size of your office within the home.
• The simplified method makes the process easier, letting you deduct $5 per square foot of area in the office, up to 300 square feet ($1,500).

Example of how home offices impact your taxes

Imagine you have a 1,200-square-foot home. You decide to take a cash-out refinance and use the proceeds, $50,000, to build a 100-square-foot home office addition.

Because you’re using the cash-out refinance for an improvement to the property, you can deduct the interest you pay on the full amount of the refinance. You can also benefit from the home office deduction.

To use the regular method, you’ll want to track and keep receipts for costs such as labor, paint, materials, and repairs that are incurred during construction. You can then deduct those costs from your income when filing your taxes.

Alternatively, you could use the simplified method and deduct $5 for every square foot of home office, in this case, 100 square feet. That means you’d be able to deduct $500 from your income.

Improve or repair a rental property

When it comes to rental properties, you can deduct much more than you can with your primary residence because you’re operating the rental property like a business. That means that the rules for deducting the interest on a cash-out refinance on a rental property you manage or own are different, with almost any repairs or improvements qualifying.

Landlords can also deduct other costs, such as:

• Improvements or repairs
• Closing costs
• Interest on the refinanced loan
• Insurance premiums
• Other business expenses, such as property management

Consult a tax professional

The tax code is complex, and real estate often costs hundreds of thousands of dollars. Any time you have questions about taxes, and especially when the dollar amounts involved are so large, it’s important to get an expert opinion.

Whether you’re an individual who is thinking about fixing up or selling your home or a real estate investor trying to improve your properties, consult a tax professional to get a better sense of what costs you can deduct when filing your taxes.

FAQ

The tax implications of cash-out refinances can be complicated. Here are several common questions about it.

Is a cash-out refinance tax-deductible?

If you’re using a cash-out refinance for capital home improvements, you may be able to deduct a portion of the interest you pay on your new mortgage from your taxes. However, if you’re planning on using the cash-out refinance for debt consolidation, home repairs, or upgrades to your home that don’t increase your property value, you won’t be able to deduct the interest from your taxes.

Will I have to pay taxes on the money I receive from the cash-out refinance?

No. Cash-out refinances allow you to borrow the equity you’ve built in your home. Since the cash you receive from the refinance is technically a loan that your lender expects you to pay back on time, the IRS won’t consider that cash as taxable income.

How can I tell if a cash-out refinance is right for me?

If you have significant equity in your home and plan to use the money for capital improvements, a cash-out refinance may be a great option. However, if you don’t have a lot of equity built up in your home, you may want to consider using a personal loan or some other type of financing to cover your home improvements.

Can I deduct the mortgage points I purchased on my refinance from my taxes?

Your mortgage lender might allow you to buy mortgage points. Mortgage points allow you to pay money up front to “buy down” your interest rate. Though these points are deductible, you often can’t deduct the full amount you pay the year you refinance. Instead, you must spread the cost over the total course of your loan.

The bottom line: Monies from your refinancing can be deductible

If you get a cash-out refinance, you may be able to deduct the interest paid on the cashed-out portion of the loan if you use that money to make improvements to your home. On the other hand, if you use it for other purposes like taking a vacation or consolidating debt, you won’t be eligible to deduct interest on the cashed-out money.

If you’re considering a cash-out refinance, consider applying for a loan with Rocket Mortgage®. Rocket’s online application is easy to fill out, letting you get a quote for a long quickly.