An Overview On Cash-Out Refinance Tax Implications
A cash-out refinance can help homeowners tap into the equity they’ve built in their property to tackle major costs, like home renovations or medical expenses. But before moving forward with this loan type, there are some cash-out refinance tax implications to keep in mind.
What Is A Cash-Out Refinance?
A cash-out refinance is a type of home loan that replaces your existing mortgage with a larger one. At closing, a portion of the larger loan amount is used to pay off your existing mortgage. But you’ll also walk away with a cash amount based on your home’s value. After refinancing, you’ll have a larger loan balance, a different interest rate and a different monthly payment.
How To Use A Cash-Out Refinance And Deduct From Your Taxes
When you take out a cash-out refinance, the rules surrounding mortgage-related tax deductions are a bit different than a traditional mortgage. The IRS sets some specific guidelines for tax deductions related to capital improvements, renovations, and mortgage points.
Below you’ll find a closer look at the possible deductions you could take on your taxes. Before committing to any of the following possibilities, consult with a tax professional. With their specialized expertise, they can help you create an efficient tax plan based on your entire tax picture.
Make Capital Improvements
Many homeowners opt to use a cash-out-refinance for home improvements. If the improvements are considered capital improvements by the IRS, then you can claim the mortgage interest deduction. To be considered capital improvements, they need improve the property, not just maintain or repair it.
A few of the improvements that can qualify as capital improvements include:
- Adding a swimming pool to your property
- Adding a privacy fence
- Adding another room to your home
- Updating your roof
- Replacing central heating or cooling systems
- Upgrading to energy-efficient windows
A few of home improvements that don’t qualify as a capital improvement include:
- Repairing a broken central heating or cooling system
- Painting interior rooms
- Repairing broken walls or windows
Capital home improvements can help your bottom line because it means you can deduct mortgage interest from your taxable income. Beyond that, capital improvements increase the total amount you’ve spent on the property, which can lower your capital gains tax obligations when you sell the home.
In either case, it’s critical to keep a detailed record of your receipts for future reference.
Add A Home Office
Home offices have grown in popularity over the years. If you are taking out a cash-out refinance to add a home office, there are a few tax savings opportunities on the table.
First, this choice of fund usage means you can deduct the cost of the interest paid on your refinanced mortgage from your income taxes.
Additionally, small business owners or self-employed individuals can claim a portion of your mortgage as a business expense. You can either claim a simplified deduction of $5 per square foot if your home office is smaller than 300 square feet, or take the regular deduction based on the size of your office in relation to the rest of your home.
However, claiming a home office deduction is only allowed if your business if entitled to regular and exclusive use of the space. For example, an office that functions as a guest room won’t be eligible. Plus, the home office must be a principal place of your business that you regularly use.
Renovate Rental Property
If you pursue a cash-out refinance on a rental property, funds used for renovations can be considered tax-deductible. That’s because renovating a rental property is a business expense for landlords.
This is one of the many tax benefits of real estate investing.
Buy Mortgage Discount Points
When closing on a cash-out refinance, the lender may allow you to purchase mortgage points. Discount points offer a mortgage interest rate discount in exchange for an upfront fee.
Depending on your loan amount, mortgage discount points can be a hefty expense. The cost is tax deductible, which can lower your tax liability. But you aren’t allowed to deduct the full amount in the same year you complete the refinance. Instead, the cost of the discount points must be spread across your loan term.
For example, let’s say that you purchase $3,000 in discount points from your lender on a 30-year refinance. Each year, you’ll be allowed to deduct $100 from your taxes until you pay off the loan.
How To Qualify For A Cash-Out Refinance
Although refinancing requirements for a cash-out refinance can vary based on the lender, most require you to have owned the home for at least 6 months.
And, of course, you’ll need to have significant home equity to borrow against. Most lenders require you to have at least 20% equity built in your home. Some lenders allow you to refinance without 20% equity, but the deal often comes with higher interest rates and fees.
If you have at least 20% equity in your home, you’ll likely also need a credit score of at least 620 for a conventional refinance loan. But your credit score could be lower to get approval for government-backed loan programs, like FHA and VA loans. With any loan type, a better credit score leads to better interest rates.
Alternatives To A Cash-Out Refinance
If you pursue a cash-out refinance mortgage, you’ll essentially replace your existing mortgage loan with a bigger one. Depending on the situation, this could present a threat to your finances.
For example, if you can’t find a lower interest rate, you could pay significantly more in interest over the life of your cash-out refinance. Plus, this loan type could come with a higher mortgage payment, straining your monthly budget.
Other loan options for those with significant home equity include home equity loans and HELOCs. Both of these loan options are tied to your home’s equity. But each is a separate loan that won’t impact your existing mortgage. For homeowners with a locked-in low interest rate, using one of these alternative options might be the most efficient choice for your finances.
The Bottom Line
You won’t have to pay income taxes on the proceeds from a cash-out refinance loan. But you’ll need to put the funds to use in certain ways to tap into tax deduction opportunities. If you are ready to harness the power of your home equity, then get started on a refinance today.