Cash-out refinance allows you to convert some of your home’s capital into cash. You can then use cash to fund anything from home improvements to university tuition and medical costs.
In some cases, you can also place the refinance of cash-outs on tax cuts. This is what you need to know.
Do you pay taxes on refinancing your cash out?
No, revenue from cash-out refinances will not be taxed. The money you receive from a cash-out refinance is a loan you are taking out against the fairness of your home and you will pay it back. Money received from HELOC or Home Equity Loan is also not taxable.
In addition to not paying income tax on revenue, you may even be able to deduct some of the interest you pay on your cash-out refinance.
Cash-out refinance tax rules
If you plan to itemize the deduction, you may be able to deduct the interest you pay on your new mortgage from your taxable income. However, you need to use cashed funds to make what is known as “capital improvement” in your home.
Deductible housing improvement projects generally increase the value of the property, extend the lifespan, or adapt it to new uses. Consider consulting with a tax professional to ensure you are qualified for the project. You will also need to store receipts and other documents related to the improvements to receive a deduction during your tax hours.
“If you can use that money to increase the value of your home and write it down, that’s a double benefit,” says Ralph Dibugnara, senior vice president of mortgage lender Cardinal Financial.
How to use cash-out refinance so interest is tax-deductible
Interest on new mortgages may be deductible if you use cash-out revenue for any of the following projects:
We will improve our capital homes
Not all projects around your home qualify as capital improvements. For example, restoring a leaky faucet is considered to be a maintenance of property rather than strengthening it.
Meanwhile, capital improvements will strengthen your wealth. An example is:
- Add a swimming pool or hot tub to your backyard
- Construction of new bedrooms and bathrooms
- Build a fence around your home
- It’s effective in strengthening the roof and protecting it from elements
- Window Upgrade
- Set up a central air conditioning or heating system
- Installing a home security system
“Improved capital needs to significantly improve your home,” says Dennis Brager, founder of Los Angeles-based Brager Tax Law Group. “Kitchen and bathroom modifications, additional rooms, and older parents modifications are all eligible. Standalone paintings are not eligible. On the other hand, if it is part of a larger modification, the cost of a painting job is qualifying.”
Add a home office
Adding a home office is a popular type of capital improvement and if you are self-employed or owning a business, you will be given a home office deduction. However, to qualify for a home office deduction, you must meet certain criteria.
- Regular and exclusive use. Office spaces should be used regularly and for business purposes only, but do not need to be marked with permanent partitions. Office spaces cannot be used for personal reasons such as playrooms or guest bedrooms.
- Major Business Locations. Your trade and business can have multiple locations. However, to claim the deduction, your home office must be your primary business location or a regular meeting of clients or clients.
Please note that employees who work from home are not eligible for this deduction.
However, if you are eligible, there are two ways to calculate your home office deduction. The simplified option offers a standard deduction of $5 per square foot in a house that can be used up to 300 square feet for business purposes. The usual method allows you to deduct actual costs based on the percentage of homes you use for your business.
Improve rental properties
Improvements and repairs for rental properties are usually tax-deductible. In this case, whether the project will maintain or improve the property (whether it will increase the resale value or rent that can be charged) will be subject to the deduction.
Deduct mortgage points for cash-out refinance
Also known as discount points, mortgage points are prepaid fees you pay to your lender in exchange for the low interest rate on your loan.
Typically, the full value of points cannot be deducted in the year you pay, whether it’s a regular mortgage or a cash-out refinance. However, you can receive a smaller deduction throughout the lifespan of your loan. For example, if you pay $2,000 mortgage points for a 15-year cash-out refinance, you can deduct approximately $133.33 per year for the duration of the loan.
Mortgage interest deduction limits limit cash-out refinances
Several restrictions apply to the interest you can deduct with cash-out refinance.
Interest deduction limit for mortgage loans
The current mortgage interest deduction limit states that you can deduct mortgage debts worth up to $750,000, or interest in $375,000 if you are married.
If you have jointly filed and your current mortgage balance is over $750,000 before refinancing your cash-out, you will not be able to deduct any interest. Similarly, if your current mortgage balance is close to $750,000 and a cash-out refinance places you on top, you can only deduct a portion of your interest.
Please note that if you purchased a home before 2017, you can deduct interest on your mortgage debt up to $1 million, or $500,000 if you are married.
Capital improvement requirements
If you use cash for anything other than capital improvements, you cannot deduct interest on the entire new mortgage. Therefore, if you use cash to pay off your credit card debt or buy a new car, you can deduct interest only on your original mortgage balance.
Let’s say you have a mortgage with a $60,000 principal and want to take out $20,000 in stock through a cash-out refinance. If you use cash to add a hot tub to your backyard, you can deduct the interest you paid (total balance) or $80,000. If you use it to pay off your credit card debt, you can only deduct the original balance, or interest paid on your $60,000.
Still, using cash-out refinances to pay off your credit card debt can be a wise financial decision. Most credit cards charge double-digit interest rates, but mortgage rates are hovering around 6-7%.
Pros and cons of cash-out refinance
While there are many advantages to refinancing cash outs, there are also significant drawbacks. These include:
Cash-out refinance alternatives
Refinancing cash-outs is not the only option for borrowing money. You might also consider an A:
- Home Equity Loan: These fixed-rate loans are now in place of your current mortgage. This may be advantageous if the rate is lower than what you get in the current market.
- Home Equity Credit Line (HELOC): Like home equity loans, HELOC is the second mortgage. In other words, you carry it in addition to your existing mortgage. HELOCs tend to have a fluctuating rate and can increase or decrease over time.
- Personal loan: These loans tend to have higher interest rates and lower borrowing restrictions than the loans your home protects, but if you are concerned about your ability to make payments, this may be a safer option.
