A cash-out refinancing loan is treated differently by the IRS than a traditional mortgage. Although you receive a lump sum of cash, cash-out refinancing is considered a form of debt restructuring, and you do not pay taxes on the cash you receive.
With cash-out refinancing, you cash out a percentage of the equity that you have accrued in your home and replace your existing mortgage with one with a higher principal. You can use the cash for any reason, such as consolidating debt, paying for home renovations, or unexpected medical expenses.
Here’s what you should know about cash-out refinancing and the tax implications.
How Cash-Out Refinancing Works
When you refinance your mortgage, you cash out equity. Equity is the difference between your current mortgage balance and the value of your home today. Let’s say your home is worth $300,000 and the balance on your mortgage is $150,000, you have $150,000 in home equity.
A lender typically requires you to keep at least 20% of the value of your home in equity. In the above case, you would leave $60,000 in equity and have $90,000 to cash out. Your mortgage lender would also charge around 1% in closing costs.
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The Tax Implications of Mortgage Refinancing
A cash-out refinancing loan is treated differently by the IRS than a traditional home loan because it is considered a form of debt restructuring. You do not pay tax on the money you receive in cash, and you might also be able to deduct some of the interest you pay on that cash from your taxes.
Here’s a closer look at the tax implications of a cash-out refinancing loan.
Is a Cash-Out Refinance Taxable?
Because the IRS considers a cash-out refinance to be a form of debt restructuring, the cash you receive is considered a loan, not income, and is not taxed. In addition, you could receive additional tax benefits depending on how you spend the money you receive.
If you use the cash to increase the value of your home, such as putting on a new addition or replacing your heating or cooling system, you can claim the interest that you pay on the loan as a tax deduction.
Before you do this, however, consult a tax professional to make sure that the work qualifies. Simple repairs like painting or general maintenance do not qualify for tax deductions. You will also have to keep meticulous records and save receipts documenting what you spend so that you can prove your case when you file your taxes.
Requirements for Interest Deductions on a Cash-Out Refinance
Capital improvements to a property that increase its value will qualify for an interest deduction. Examples could include a new addition, a security system, or a new swimming pool. General maintenance and repairs will not qualify, nor can you deduct the interest you pay on the loan if you spend the money on a vacation, medical bills, or credit card debt.
How to Make a Cash-Out Refinance Tax-Deductible
Below is a list of home improvements that qualify for the interest deduction.
Qualifying Home Improvements
• Renovating or adding on an addition, such as a garage or a bedroom
• Putting in a swimming pool
• New fencing
• New roof
• New heating or cooling system
• Installing efficient windows
• Installing a home security system
Improving your property’s value means you can also save money if 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 when you sell your home.
Deductions for Adding a Home Office
Adding a home office to your home is a capital improvement that qualifies for the interest deduction on a cash-out refinancing loan. There are also additional potential tax benefits to adding a home office for small businesses or the self-employed.
How Home Offices Can Impact Your Taxes
You can deduct the interest on your cash-out refinancing loan if you use the money to add a home office, because it will increase the value of your home and is considered a capital improvement. If you are a business owner or self-employed, you could also qualify for the home office deduction on your federal taxes.
The home office deduction is a benefit that allows you to claim a percentage of what you pay on your loan as a business expense. You must use the designated office space for business purposes only, and it cannot be used as a spare bedroom or family space or it will not qualify. Also, your home office must be the primary place where you conduct business.
Recommended: What to Know Before You Deduct Your Home Office
Tax Implications of a Cash-Out Refinance for Rental Property
Rental income is considered personal income by the IRS. If you use the capital from a cash-out refinance to improve or repair a rental property, the expenses are tax-deductible. Also, interest, closing costs, and insurance paid on a rental property can be deducted from your income as business expenses.
What Are the Limitations for Interest Deduction with a Cash-Out Refinance?
For the 2022 tax year, single filers and married couples filing jointly could deduct mortgage interest up to $750,000. Married taxpayers who file separately could deduct up to $375,000 each. (The limit is higher for debts incurred prior to December 16, 2017: $1 million or $500,000 each for married couples filing separately.)
Can You Deduct Your Mortgage Points?
Mortgage points, also known as discount points, are fees you pay a lender upfront so that you can pay a lower interest rate on your loan. One point is equal to 1% of your mortgage loan. With a cash-out refinance, you cannot deduct the money you paid for points in the year you refinanced until after 2025. But you can spread out the cost throughout the loan. That means if you accumulate $2,500 worth of mortgage points on a 15-year refinance, you can deduct around $166 per year throughout the loan.
Risks of a Cash-Out Refinance
Cash-out refinancing is a risk. You are taking on a larger loan than your original home mortgage, which means that your monthly mortgage payment will increase unless interest rates are lower than when you applied for your current mortgage. If your payments are higher and you can’t keep up with them, you could be at greater risk of foreclosure.
Alternatives to a Cash-Out Refinance
Two financing alternatives that also use equity in your home are a home equity loan or a home equity line of credit (HELOC).
A home equity loan is a second mortgage for a fixed amount that you repay over a set period while keeping your original loan. The payments include interest and principal, just like a traditional mortgage, but the interest rate may be higher than a primary mortgage. This is because the primary lender is paid first in the event of foreclosure, so the secondary lender takes on more risk.
A home equity line of credit (HELOC) is also a second mortgage but with a revolving balance. That means you can borrow a certain amount, pay it back, and then borrow again. As with a credit card, your payments are based on how much you use from the line of credit, not on the available credit amount. If you don’t need to borrow a large sum, this might be a cheaper option than cash-out refinancing because a HELOC tends to have a lower interest rate.
Recommended: Home Equity Loans vs HELOCs vs Home Improvement Loans
The Takeaway
Cash-out refinancing is a way to access the equity in your home and use it to pay for expenses, though it does mean taking on increased debt. The cash from this type of mortgage refinancing can be used any way you like, such as to pay for home renovations, college, or unexpected medical expenses.
When you opt for cash-out refinancing, your original mortgage is replaced by a larger mortgage. If interest rates are lower than when you took out your original mortgage, your monthly payments may go down, but it will take you longer to pay off the loan. Depending on how much cash you need, you can also consider a HELOC or a home equity loan to obtain the money you need.
Turn your home equity into cash with a cash-out refi. Pay down high-interest debt, or increase your home’s value with a remodel. Get your rate in a matter of minutes, without affecting your credit score.*
FAQ
Is cash-out refinance tax-deductible?
Some of the interest you pay on a cash-out refinancing loan might be tax deductible if you use the money to make capital improvements on your home and you keep meticulous documentation to prove it. It’s best to consult with a tax professional to make sure the improvements you do on your home qualify for the deduction.
Do you pay taxes on a cash-out refinance?
No. The funds you receive from cash-out refinancing are not subject to tax because the IRS considers refinancing a form of debt restructuring, and the money isn’t categorized as income.
How do I report a cash-out refinance on my tax return?
You don’t need to report the cash you receive from a cash-out refi as income, so the refi would only show up if you record the interest you are paying on the new mortgage on an itemized return.
What are the tax implications of a cash-out refinance on a rental property?
Rental income is taxed as personal income by the IRS. The good news is that if cash from a refinancing is used to improve or repair a rental property, the expenses are tax-deductible. Also, closing costs, interest, and insurance paid on a rental property may also be deductible from your income as business expenses.
How does the timing of a cash-out refinance affect my taxes?
As long as you meet the requirements for capital improvements, you can deduct the interest paid on your refinanced loan every year that you make payments throughout the life of your refinance loan. So, if you refinance your mortgage to a 15-year term, you must spread your deductions over the 15 years. However, you can only deduct the interest you pay each year, and the amount of interest paid will become less as the loan matures and you pay more toward the principal.
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