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Cash-Out Refinance Tax Implications: How to Get the Most Bang for Your Buck
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U.S. homeowners have accumulated significant home equity in recent years, with $11.5 trillion in taxable equity as of June 2024 (ICE Mortgage Monitor, 2024). This surge presents an opportunity to create liquidity by tapping into their home equity via a cash-out refinance.
LESSON CONTENTS
Understanding cash-out refinance tax implications
A cash-out refinance allows you to replace your existing mortgage loan with a new one that's larger than the outstanding balance. The difference is given to you in cash, which you can deploy for various purposes like home improvements, auto loan refinance, debt consolidation, or investing. While this financial strategy can unlock significant benefits, it's crucial to understand the cash-out refinance tax implications. Below, we highlight the tax consequences associated with a cash-out refinance.
Common tax implications of cash-out refinance
One of the most common questions is whether the cash received from a cash-out refinance is taxable. The answer is no. The Internal Revenue Service (IRS) does not consider loan proceeds as income because you're borrowing against your own assets. However, the tax implications of refinance cash-out largely depend on how you use the funds.
Interest deductibility
Mortgage interest is deductible under the Tax Cuts and Jobs Act of 2017. If you itemize your deductions, the IRS allows you to deduct interest on your new cash-out refinance loan up to $750,000 for married couples filing jointly and $375,000 for single filers.
However, deductions are only eligible if the cash-out refinance funds are used to add to or substantially improve your primary or secondary residence. As the IRS outlines in Publication 936, interest on home equity loans used to build an addition to an existing home is deductible (IRS, 2024).
Limitations on deductions
If you use the cash-out funds for personal expenses unrelated to home improvement, the interest on that portion of the refinance loan is not tax-deductible. For instance, interest is not deductible if funds pay for personal living expenses, such as credit card debts.
Tax implications for rental properties
Do you own a rental property? The tax implications of cash-out refinance rental property offer unique advantages and considerations.
Deductible interest for business purposes
If you use the funds from a cash-out refinance to improve your rental property, the interest on the new loan is typically fully deductible against your rental income. This is because the IRS treats the property as a business asset. However, interest on the portion used for non-rental uses isn’t deductible.
The IRS outlines this criterion in its rules:
You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense. (IRS Publication 527, 2024)
Adjusted basis and depreciation
Improvements made using the cash-out funds increase the property's adjusted basis, which can enhance your depreciation deductions. Depreciation allows you to recover the cost of wear and tear on your rental property, reducing your taxable income.
Record-keeping is essential
Maintain meticulous records of how you use the funds. The IRS may require proof that the cash-out proceeds were used for business purposes to allow the interest deduction.
Tax implications for investment properties
A cash-out refinance can help you unlock capital without selling the property. For investment properties, the cash-out refinance investment property tax implications are similar but come with additional layers.
Tracing rules
The IRS uses tracing rules to determine how borrowed funds are used and whether the interest is deductible. If you use the cash-out funds to purchase another investment property or for other investment activities, the interest is deductible against investment income.
Potential pitfalls
Using the funds for personal expenses means the interest is not deductible. Additionally, if the investment property is sold, the outstanding debt from the refinance doesn't reduce your taxable gain.
FAQs
What are the general tax implications of a cash-out refinance?
Generally, the cash you receive from a cash-out refinance isn't considered taxable income. However, the cash-out refinance tax implications depend on how you use the funds. Interest is deductible if used for home improvements but not for personal expenses like vacations or paying off unsecured debts.
How does a cash-out refinance affect taxes on a rental property?
For rental properties, the tax implications are favorable. If you use the funds for qualifying property improvements, the interest is usually deductible against rental income. Additionally, improvements can increase depreciation deductions.
Are there different tax rules for cash-out refinance on investment properties?
Yes, the tax implications of a cash-out refinance on an investment property involve specific IRS tracing rules to determine interest deductibility. When comparing a cash-out refinance vs HELOC, using the funds for investment purposes can make the interest deductible against investment income, whereas personal use of funds typically disallows the deduction.
Can I deduct interest from a cash-out refinance on my taxes?
You can deduct the interest if the funds are used for qualified purposes like substantial home improvements or investment activities. Under current tax laws, interest on funds used for personal expenses is generally not deductible.
What steps can I take to minimize tax impacts from a cash-out refinance?
- Use funds wisely: Allocate funds toward expenses that qualify for interest deductions.
- Maintain records: Keep detailed documentation of how you use the funds.
- Professional guidance: Consult a tax professional to tailor strategies to your situation.
- Stay updated: Keep abreast of tax law changes that may affect your deductions.
Citations
ICE Mortgage Monitor Report (2024, August). Mortgage Monitor Report August 2024. https://static.icemortgagetechnology.com/pdf/august-2024-mortgage-monitor-report.pdf
Internal Revenue Service (2024). Publication 936 (2024, September 9), Home Mortgage Interest Deduction. https://www.irs.gov/publications/p936
Internal Revenue Service (2023). Publication 527 (2024, September 9), Residential Rental Property. https://www.irs.gov/publications/p527
*PLEASE NOTE: This article is intended to be used for informational purposes and should not be considered financial advice. Consult a financial advisor, accountant or other financial professional to learn more about what strategies are appropriate for your situation.
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