Many Americans are eager to take advantage of cash out refinancing. A well-structured cash-out refinancing solution can provide you with the cash proceeds for home improvements, debt consolidation, or pursuing a new venture - all while maintaining ownership of your property. Many property owners, especially real estate developers and landlords, use cash out refinancing to acquire the liquid capital they need to grow their portfolios or improve the value of their properties.
But there’s one big question you need to answer: How will a cash out refinance affect your tax bill at the end of the year? Today, let’s look at the tax implications of cash out mortgage refinancing in detail.
Understanding Cash-Out Refinancing
Cash out refinancing, in a nutshell, involves taking out a new mortgage loan for your property that’s worth more money than your current remaining principal balance. You use the cash out refinancing loan to pay your original mortgage, then pocket the difference at closing.
The amount you can cash-out on your property is dependent on the amount of equity you have in the property — the more equity you’ve built up, the greater the difference between your original mortgage and a theoretical cash out refinance mortgage you could pocket.
Property owners that have no existing mortgage on their property can also take advantage of a cash-out refinance. When you refinance a property you own outright, you are essentially taking out a new first mortgage that allows you to borrow a large sum of money against your property.
How Cash-Out Refinancing Works in Real Estate
Say you have a property worth $700,000 with $300,000 left in the principal balance. Put another way, you’ve built $400,000 in equity.
You take out a cash out refinancing loan worth $400,000. Once you have the money, you pay the $300,000 remaining on your first mortgage, then have $100,000 to use as you please.
In effect, the cash out refinancing loan replaces your original mortgage, complete with its own terms, interest rate, fees, etc. You then pay down the remaining principal balance for your cash out refinancing loan (in this example, $400,000) over time.
Many real estate lending firms offer specialized cash out refinancing solutions tailored to real estate purchasing, development, and renting needs. Depending on how much equity you've built in your properties so far, you could see a significant cash infusion without having to sell the property.
Tax Implications of Cash Out Refinancing
Although a cash-out refinance can have many advantages, it's important to have a full picture and weigh out the disadvantages, such as how it will affect your federal income tax.
Upfront, the IRS does not consider the money you “make” from a cash out refinance to be income. Instead, the IRS considers that money a debt you’ll eventually have to repay. Therefore, you do not have to report any income from a cash out refinance on your federal tax return.
The money you receive from a cash out refinancing deal can theoretically be deducted from your taxes each year. However, whether or not you qualify for tax deductions based on money from a cash out refinance depends on things like:
How you use the money
Whether or not you live in the property or it’s a rental property you oversee
Mortgage Interest Deduction Parameters
Let’s start with mortgage interest deductions, also called mortgage points or discount points.
If you pay extra money at the closing of a mortgage loan, including a cash out refinancing loan, you’ll receive a lower interest rate. With a standard mortgage, these mortgage points are deductible because the IRS considers them to be prepaid interest.
With a cash out refinance, mortgage points aren’t fully deductible for the income taxes in the year in which they are paid. Rather, you can take a deduction on your mortgage points spread out over the lifespan of the loan. Overall, this is a small advantage, but one you may still want to keep in mind each year you pay your tax returns.
Furthermore, you have to qualify for IRS criteria to take this tax deduction, including:
You must live in the home that the loan is for. In other words, you cannot deduct the mortgage points for a rental property you purchase or refinance.
Paying mortgage points has to be a standard business practice in your area, as well.
You must also use the cash out proceeds to make capital improvements to your home (see more below).
Furthermore, you can take a mortgage interest deduction on cash out funds. But again, you must use them for a home improvement that directly increases your home’s value.
A "capital improvement" is one that adds direct market value to your property. For example, if you use a cash out refi's proceeds from a refinancing loan to add a pool in the backyard, that improvement will qualify, and you could potentially deduct the mortgage interest from your new loan.
Here’s an example:
Say that you have a loan for $100,000, and you put $10,000 or 10% toward putting in a pool.
In this case, you can deduct 10% of the mortgage points paid from the taxes in that year.
You can deduct a portion of the mortgage points paid in the year of the refinance based on the percentage of the loan amount used for capital improvements. In this case, it's 10%. So, you can deduct 10% of the $5,000 points, which equals $500 in the first year.
The remaining $4,500 in points ($5,000 - $500) will be spread out evenly over the remaining years of the loan. Each tax year, you can deduct a portion of this amount. The exact annual deduction would depend on the length of the loan, but it's typically divided equally over the loan's lifespan.
The exact amounts and timing of these deductions will depend on the terms of the loan and the specific tax rules in your region. It's advisable to consult with a tax professional or refer to the latest IRS guidelines for precise calculations and any changes in tax laws.
Tax Implications for Spending the Cashed-Out Funds
As broken down above, the way you spend your cash out funds heavily determines whether you can make a tax deduction for them. You must make a home improvement with the money from a cash out refinance to qualify for a tax deduction in all cases.
Adding a deck to your property, adding a home office, updating your bathroom, adding impact windows, and so on are examples of projects that qualify. However, repairs, vacations, debt repayment, and all other uses of the money from a cash out refinance do not qualify. In other words, it has to directly increase the market value or utility of your property.
This is a significant consideration for real estate developers and investors. For instance, you can take a cash out refinance for a property you want to repair back into livable condition. But the money from that cash out refinance will not be deductible on your tax return, so the financial decision should be based on factors like future rent, sales price, or other financial returns.
Capital Gains and Property Value Appreciation
The IRS taxes capital gains, which are any profits you get from the sale of an asset that is already subject to taxation. For example, if you sell a property, you’ll have to pay taxes on the capital gains you receive from that sale.
How does cash out refinancing play into this? If you refinance your property and pocket the proceeds, that money isn’t treated as income, nor is it treated as capital gains. This is because a cash-out refinance is essentially a restructuring of your existing debt, and it does not involve the sale of the property. Therefore, the money received through a cash-out refinance is typically not subject to immediate taxation.
In this way, real estate developers and investors often use cash-out refinancing to secure larger loans for the same property, pay off existing mortgages, and access capital for new investment projects without incurring immediate taxes on those funds. This can be a valuable financial strategy for leveraging real estate assets to fund future investments.
Navigating Potential Pitfalls
Even though cash-out refinancing can be an effective and valuable tool, it’s important not to misuse it. Many homeowners and real estate investors encounter some difficulties or pitfalls with cash out refinancing, including:
Misunderstanding Tax Deductions: While the funds themselves are not typically taxable, the way they are spent or used may have tax implications. For example, if the funds are used for non-qualifying purposes, such as vacations or personal expenses, they may not be tax-deductible.
Paying Off Other Debts: Using cash proceeds from a cash-out refinance to pay off high-interest debts, such as credit cards, is a smart financial strategy. However, it's vital to learn from past habits and diagnose how you got into debt in the first place to prevent further debt accumulation and make the most of your "clean slate."
Net Income Increase: If the refinancing doesn't result in a net increase in income or if it doesn't lead to financial improvements, individuals may still face high tax bills, especially if they have additional tax liabilities related to other financial activities.
Consult With Professionals
Given these possible pitfalls, it’s a good idea to consult with a tax professional and review the latest IRS guidelines for a full picture of the long-term tax implications and make informed financial decisions.
While the work we do at Vaster is not a substitute for tax advice, we do offer cash out refinance solutions, including both long-term and short-term options, that can help real estate investors and homeowners tap into their property's equity. Connect with a Vaster loan specialist to start exploring your refinance possibilities.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the U.S. Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.