Cash-Out Refinance Tax Implications | Bankrate

A cash-out refinance lets you turn a portion of your home’s equity into cash. You can then use the cash to fund anything from home improvements to college tuition or medical bills.

In some cases, you may also be able to parlay your cash-out refinance into a tax break. Here’s what you should know.

Do you pay taxes on a cash-out refinance?

No, the proceeds from your cash-out refinance are not taxable. The money you receive from your cash-out refinance is a loan you’re taking out against your home’s equity and which you’ll pay back. Money received from a HELOC or a home equity loan is also not taxable.

In addition to not paying income taxes on the proceeds, you might even be able to deduct some of the interest you pay on your cash-out refinance.

Tax rules for cash-out refinances

If you plan to itemize deductions, you may be able to deduct the interest you pay on your new mortgage from your taxable income. But you must use the cashed-out funds to make what are known as “capital improvements” to your home.

Deduction-eligible home improvement projects generally increase the property’s value, extend its longevity or adapt it for new uses. Consider consulting with a tax professional to ensure your projects qualify. You’ll also have to save receipts and other paperwork associated with the improvements in order to receive the deduction at tax time.

“If you’re using that money to increase the value of your home, and you get to write it off, it’s a double benefit,” says Ralph DiBugnara, senior vice president of mortgage lender Cardinal Financial.

How to use your cash-out refinance so the interest is tax-deductible

The interest on your new mortgage is likely to be deductible if you use the cash-out proceeds for one of the following projects:

Make capital home improvements

Not all projects around your home will qualify as a capital improvement. For example, repairing a leaky faucet would be considered maintaining your property rather than enhancing it.

A capital improvement, on the other hand, enhances your property. Examples include:

• Adding a swimming pool or hot tub to your backyard
• Constructing a new bedroom or bathroom
• Erecting a fence around your home
• Enhancing your roof to make it more effective in protecting against the elements
• Upgrading windows
• Setting up a central air conditioning or heating system
• Installing a home security system

“Capital improvements must substantially improve your home,” says Dennis Brager, founder of the Los Angeles-based Brager Tax Law Group. “Kitchen and bathroom remodels, room additions, modifications for an elderly parent would all qualify. A standalone painting would not qualify; on the other hand, if it was just part of a larger remodel, then the cost of the paint job would qualify.”

Add a home office

Adding a home office is a popular type of capital improvement, and it sets you up to take the home office deduction if you’re self-employed or own a business. However, you’ll need to meet specific criteria to qualify for the home office deduction:

• Regular and exclusive usage. You must use the office space regularly and solely for business purposes, though you don’t need to mark it off with a permanent partition. The office space cannot be used for personal reasons, such as a playroom or a guest bedroom.
• Principal place of business. Your trade or business can have more than one location. However, to claim the deduction, your home office must either be your main place of business or where you regularly conduct customer or client meetings.

Note that employees who work from home don’t qualify for this deduction.

If you do qualify, though, there are two ways to calculate the home office deduction. The simplified option gives you a standard deduction of $5 per square foot of home you use for business purposes, up to 300 square feet. The regular method lets you deduct actual expenses based on the percentage of the home you use for business.

Improve your rental property

Improvements and repairs to rental properties are typically tax-deductible — including when you fund them with money from a cash-out refinance. In this case, whether the projects maintain or improve the property — increasing its resale value or the rent you can charge — they qualify for the deduction.

Deducting mortgage points on a cash-out refinance

Also called discount points, mortgage points are upfront fees you pay a lender in return for a lower interest rate on your loan.

The full value of points typically isn’t deductible in the year you paid them, whether with a regular mortgage or a cash-out refinance. However, you can take smaller deductions throughout the life of the loan. For example, if you paid $2,000 in mortgage points on a 15-year cash-out refinance, you can deduct about $133.33 per year for the duration of the loan.

Mortgage interest deduction limits with a cash-out refinance

A few limits apply to the interest you can deduct on a cash-out refinance.

Home mortgage interest deduction limit

The current home mortgage interest deduction limit states that you can deduct interest on up to $750,000 worth of mortgage debt, or $375,000 if you’re married filing separately.

If you’re married filing jointly, and your current mortgage balance totals $750,000 or more before the cash-out refinance, you won’t be able to deduct the interest. Similarly, if your current mortgage balance is near $750,000, and your cash-out refinance puts you over the top, you’ll be able to deduct only a portion of your interest.

Keep in mind that if you purchased your home in 2017 or earlier, you may deduct interest paid on up to $1 million of mortgage debt, or $500,000 if married filing separately — but if you take out a cash-out refinance today, that interest is still subject to the current limits.

Capital improvement requirement

You cannot deduct the interest on the entire new mortgage if you use the cash for anything other than capital improvements. So if you use the cash to, say, pay off credit card debt or buy a new car, you can deduct the interest only on the original mortgage balance.

Let’s say you have a mortgage with a $60,000 principal, and you want to take out $20,000 in equity through a cash-out refinance. If you use the cash to add a hot tub to your backyard, you can deduct the interest you paid on the total balance, or $80,000. If you use it to pay off your credit card debt, you can deduct only the interest you paid on your original balance, or $60,000.

Even so, using a cash-out refinance to pay off credit card debt can be a smart financial decision. Most credit cards charge double-digit interest rates, while mortgage interest rates are hovering around 6 to 7 percent.

Pros and cons of a cash-out refinance

There are many benefits to a cash-out refinance, but there are also notable drawbacks. These include:

Pros

• May qualify for more money than with other loan types
• May receive a lower rate than with other loan types
• Some uses are tax-deductible

Cons

• Stringent rules regarding tax deductions
• Larger mortgage balance
• Potential for a higher interest rate on mortgage
• Risk of foreclosure if payments aren’t made

Alternatives to a cash-out refinance

A cash-out refinance isn’t your only option for borrowing money. You might also consider a:

• Home equity loan: These fixed-rate loans leave your current mortgage in place, which may be an advantage if your rate is lower than what you could get on the current market.
• Home equity line of credit (HELOC): Similar to a home equity loan, a HELOC is a second mortgage, meaning you carry it in addition to your existing mortgage. HELOCs tend to have variable rates, which can increase or decrease over time.
• Personal loan: These loans tend to have higher interest rates and lower borrowing limits than loans secured by your home — but if you’re at all concerned about your ability to make payments, this may be a safer option.

FAQ

• Do I need to provide documentation or proof of how I used the cash from a cash-out refinance for tax purposes?
  

  If you plan to write off your mortgage interest, you’ll need to save receipts and other paperwork related to capital projects to prove that the work completed on your home is eligible for a deduction. Consider filing with a tax professional to ensure you have the necessary proof.

• Can I deduct any closing costs or fees associated with a cash-out refinance on my taxes?
  

  You can deduct only certain closing costs related to a mortgage refinance on your taxes. While you can’t deduct the cost of title insurance and appraisals, you may be able to deduct some or all of the interest paid and the cost you pay for points to get a lower interest rate.