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. Before moving forward with this loan type, there are some cash-out refinance tax implications to consider.
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 also walk away with a cash balance based on your home’s value. After refinancing, you’ll have a larger loan balance, a different interest rate and a different monthly payment.
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Do You Pay Taxes On A Cash-Out Refinance?
No, you do not have to pay income tax on the money you get through a cash-out refinance. The funds from a cash-out refinance are not taxable because the IRS does not view the equity as income. Instead, money from a cash-out refinance is treated as a loan.
Tax Deductions When Using A Cash-Out Refinance
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, we take 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 Substantial Improvements
Many homeowners opt to use a cash-out-refinance for home improvements. If the IRS considers these substantial improvements that add value to the home, adapt the home to new uses or prolong its useful life, then you can claim the mortgage interest deduction. To be considered capital improvements, you must improve the property, not just maintain or repair it.
Qualified Substantial Improvements
A few of the improvements that can qualify as substantial 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
Repairs That Don’t Qualify As Substantial Improvements
A few home improvements that don’t qualify as substantial improvement include:
- Repairing a broken central heating or cooling system
- Painting interior rooms
- Repairing broken walls or windows
Substantial Improvements Via A Cash-Out Refinance Can Affect A Tax Assessment
Your cash-out refinance may increase the value of the home through a substantial improvement, which could impact a tax assessment. For example, building an addition on your house would increase the assessed value and increase property tax liability. This is called an increase in basis.
In either case, it’s critical to keep a detailed record of your receipts for future reference.
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Types Of Cash-Out Refinance Tax Deductions
Let’s take a look at some specific situations where you’re entitled to tax deductions after a cash-out refinance. We’ll also touch on what the deduction looks like for each kind of improvement. Here are some examples:
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, because you’re choosing to make a capital improvement, 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.
A home office qualifies as deductible if:
- The home office is used exclusively for your business
- The home office is your principal place of business
A home office won’t qualify for tax benefits if:
- The office also functions as a guest room or living space
- Your home office isn’t your primary workplace
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. Most of the time, you can’t deduct the full amount in the same year you complete your refinance. Generally, 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 can deduct $100 from your taxes until you pay off the loan. It’s best to consult with a tax professional for help understanding how your specific situation works.
How To Qualify For A Cash-Out Refinance
Although refinancing requirements for a cash-out refinance can vary based on the lender. Here are some of the requirements you can expect when applying for a cash-out refinance:
- Wait period: Lenders will have their own wait times before you can borrow money in a cash-out refinance. Most lenders require you to own the home for at least 6 to 12 months before a refinance.
- Amount of equity: You need significant home equity to borrow against. Most lenders require you to have at least 20% equity built in your home. This means, in order to take cash out, you would need to have more than that 20%. For example, if you had 40% equity in your home, you could use that extra 20% for cash out purposes.
- Credit score: You’ll likely also need a credit score of at least 620 for a conventional refinance loan. You could qualify for a government-backed loan program, like Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans, with a lower credit score. With any loan type, a better credit score leads to better interest rates.
Alternatives To A Cash-Out Refinance
When you pursue a cash-out refinance mortgage, you replace your existing mortgage loan with a bigger one. Depending on the situation, this might not be the right option for your finances.
The current market and the terms of your original mortgage may influence your financing choices. For example, you may want to keep your lower interest rate mortgage and opt for another type of financing. Let’s take a look at some of the other financing options that tap into your equity:
- Home equity loans: A home equity loan still taps into your equity, but is a separate loan that won’t impact your existing mortgage. You’ll still get a lump sum payout and the benefits of a low interest rate secured by your home. That said, a home equity loan will mean you have two payments to keep track of each month.
- Home equity line of credit (HELOC): A HELOC is secured by your home, but functions similarly to a credit card. These loans are favored by borrowers with recurring expenses. For example, you might choose a HELOC for a renovation if you’re anticipating changes to cost during the remodeling process.
For homeowners with a locked-in low interest rate, using one of these alternative options might be the most efficient choice for your finances, since it could help you keep the low rate on your current mortgage.
FAQ
Now that you know the basics, let’s look at some common questions about the tax benefits of a cash-out refinance.
The Bottom Line
In some cases, 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.
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Sarah Sharkey
Sarah Sharkey is a personal finance writer who enjoys diving into the details to help readers make savvy financial decisions. She’s covered mortgages, money management, insurance, budgeting and more. She lives in Florida with her husband and dog. When she's not writing, she's outside exploring the coast. You can connect with her on LinkedIn.
