A cash-out refinance allows homeowners to replace their existing mortgage with a new one, borrowing more than what they currently owe and receiving the difference in cash. The questions often arises: Is the cash received from a cash-out refinance taxable income? Can I deduct the interest paid on a cash out refinance like a traditional mortgage for tax purposes?
While it may seem like extra money, the Internal Revenue Service (IRS) has specific rules governing what constitutes taxable income. This article explores whether you need to pay taxes on cash-out refinance funds and the circumstances that can affect your tax liability.
Is Cash-Out Refinance Income Taxable?
The IRS does not consider the cash received from a cash-out refinance as taxable income.
Why? Because it is technically borrowed money, not income.
When you take out a loan, you are obligated to repay it, and thus it does not count as earned or taxable income.
Think of a cash-out refinance as temporarily shifting money from one pocket to another—it’s still yours, but it must eventually be returned.
Even though you receive cash at closing, the IRS treats the transaction as a loan modification, not a source of profit. As long as the borrowed amount is repaid according to the loan terms, no taxes are due on the cash received. There is no cash out refinance tax due.
Exceptions and Tax Considerations
While the cash itself is not taxable, there are certain situations where tax implications may arise, particularly related to how the funds are used and the impact on mortgage interest deductions.
A. Using the Cash for Personal Expenses
If you use the cash from a refinance for personal purposes, such as a vacation or a new car, the interest on that portion of the loan is generally not deductible. The IRS only allows mortgage interest deductions if the loan proceeds are used to buy, build, or substantially improve your home.
Doesn’t it make sense to use the funds wisely if it can influence your tax deductions?
B. Mortgage Interest Deduction Limitations
The Tax Cuts and Jobs Act (TCJA) of 2017 placed limits on the amount of mortgage debt eligible for interest deductions. For mortgages taken out after December 15, 2017, interest is only deductible on loans up to $750,000 ($375,000 for married taxpayers filing separately). If your cash-out refinance brings the total loan amount above these limits, you may lose some or all of the deduction.
Tax Implications of Investment Property Refinancing
If you refinance an investment property and use the cash for property-related expenses, such as repairs or improvements, the interest may still be deductible as a business expense. However, if you use the funds for personal expenses, you may not be able to claim the interest deduction. Consulting with a tax professional is recommended to navigate the rules specific to rental properties.
Why risk missing out on potential tax benefits when a little planning can go a long way?
Capital Gains and Cash-Out Refinancing
One common misconception is that a cash-out refinance triggers capital gains tax. However, refinancing a mortgage does not involve the sale of the property, so no capital gains tax applies. You would only owe capital gains tax if you sold the property for a profit above the allowed exclusion amount (currently $250,000 for single filers and $500,000 for married couples filing jointly). Again there is no cash out refinance tax when you pull money out using a mortgage.
Think of refinancing as rearranging the furniture in your home—it changes the layout, but you’re still living in the same space.
Cash Out Refinance Closing Costs and Tax Deductions
While most closing costs on a cash-out refinance are not tax-deductible, some fees—such as prepaid mortgage interest—may be deductible. Keep records of your closing documents and consult a tax advisor to understand which expenses, if any, you can deduct on your tax return. What closing costs are tax deductible on mortgage refinances?
Strategies to Minimize Tax Impact
Here are a few strategies to optimize tax benefits when using a cash-out refinance:
- Use Funds for Home Improvements: Interest on the portion of the loan used for qualified home improvements remains tax-deductible.
- Keep Loan Amounts Below IRS Limits: Stay within the $750,000 loan limit to retain your mortgage interest deduction.
- Separate Personal and Business Expenses: If refinancing an investment property, keep personal and business expenses separate to maximize deductions.
Takeaway on No Taxes on Cash Out Refinance Loans
In most cases, cash-out refinance funds are not taxable since they represent borrowed money rather than income. However, how you use the funds can affect your mortgage interest deduction, and it’s essential to understand the IRS guidelines to maximize your tax benefits. Whether for personal use or property improvements, planning ahead ensures you make the most of your refinancing strategy.
Isn’t it worth taking the time to understand these rules to avoid unexpected surprises come tax season? There is no cash out refinance tax placed on the funds you use from the loan.
With proper knowledge and expert advice, homeowners can leverage cash-out refinancing to achieve their financial goals without triggering unnecessary tax liabilities.
FAQ
What Are the Rules for Tax Deductions on Cash Out Refinance?
When completing a cash-out refinance, the interest is only deductible on the portion of your new mortgage used for capital improvements—permanent additions or upgrades that substantially enhance your property’s value. However, if the cash is used for other purposes, such as paying down debt, the interest on that portion of the loan is not eligible for a tax deduction.
What are the tax implications cash-out refinance rental property?
Some 2nd home refinancing expenses qualify for tax deductions, while others do not. Common deductions include mortgage interest, discount points, and closing costs for a refinance on a rental property. Like the primary residence, the IRS allows homeowners to deduct the interest on a cash-out refinance on an investment property or second home if the borrower is using the funds for home improvements, construction or rehabilitation that could increase the property value.
Is HELOC interest tax deductible?
Similar to cash out refinancing, the IRS allows borrowers to deduct the interest on a HELOC if they are using it for home improvement projects with the goal of home appreciation. To deduct interest on your second home used as a rental property, report it on Schedule E, including any improvements made using HELOC funds. Ensure you maintain receipts and invoices as proof that the HELOC funds were used specifically to buy, build, or improve the investment property securing the home equity loan.
References:
Internal Revenue Service (IRS). (2023). Publication 936: Home mortgage interest deduction.
U.S. Department of Housing and Urban Development (HUD). (2023). Understanding cash-out refinance options.
About RefiGuide
Bryan Dornan is a financial journalist and currently serves as Chief Editor of RefiGuide.org. Bryan has founded several mortgage and marketing companies and has worked as a loan officer and mortgage broker in the industry for over 25 years and has a wealth of experience in providing mortgage clients with the highest level of service in the industry. Bryan's continual focus is to promote affordable home-ownership to consumers like you across the United States. He also writes for RealtyTimes, Patch, Buzzfeed, Medium and other national publications. Find him on Twitter, Muckrack, and Linkedin
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