Cash-out refinances convert some of your equity into cash. A cash-out refinance is not taxable because it is considered a loan and not income.
If you take out a cashout refinance, you might be eligible for a tax deduction. We’ll take a closer look at how a cash-out refinance can affect your tax bill and what you might be eligible for a tax deduction.
What tax implications does a cash-out refinance have?
You can replace your mortgage with a larger loan by taking out a cash-out refinance. Then you can cash in the difference. You will need to repay the cash you get over time.
The IRS does not usually consider it income. Cash-out refinances are considered loans, so you don’t need to include it in your income calculations when you file your taxes.
Even though you won’t have to pay taxes on a cash out refinance, you need to be aware of the tax implications.
One of the advantages of home loans, such as a cash-out refi, was the ability to deduct taxes on interest paid. This was regardless of how the funds were used. The IRS would then give you some of the tax-paid money.
The Tax Cuts and Jobs Act of 2017, changed the rules for home loan interest deductions. You will no longer be eligible for a tax deduction on a cash out refinance if certain criteria are met. We’ll discuss these below. Your interest will not be automatically deducted.
How can you refinance a cash-out?
The IRS will not allow you to deduct interest on cash-out refinances if you use cash to consolidate debt. However, you may be eligible for a deduction if your proceeds are used towards the following:
Making capital home improvement
A cash-out refinance can help lower your tax bill by allowing you to invest in capital home improvements to increase the value of your home, make it more durable or adapt to changing needs.
These could include permanent updates like…
- Add a bathroom or bedroom
- Energy-efficient windows and doors
- Upgrading the roof
- Upgrade of the HVAC system
Setting up your home office
You may be eligible to deduct interest paid towards your cash-out refinance if you are self-employed or own a small business. You must only use your home office to conduct business and prove that it is your main location.
You can choose one of these methods to calculate your deduction.
- Simple method — Calculate the square footage of your house and subtract $5 per square foot. This method allows you to deduct up 300 square feet, or $1,500.
- Standard Method — If your home office measures more than 300 square feet, then the standard method is right for you. This method allows you to deduct certain costs associated with your home based on how big your office is.
Buying mortgage point
Buy mortgage points to reduce your interest payments for a cash-out refinance. Your mortgage rate can be reduced by buying points. This route will not allow you to claim all points in the year that you refinance. Your deductions will need to be spread over many years.
Let’s suppose you refinance your cash-out loan for 15 years, and then buy $2,000 in points. You could subtract $133 from your taxes for each year that you have the loan.
Next: Other options to consider
There are alternatives to consider if a cash-out refinance is not an option.
- HELOC A HELOC (or home equity line) allows you to borrow money from your home and then pay it back just like a credit card.
- Home equity loan Home Equity loans are similar to HELOCs, but have fixed interest rates as well as lump sum amounts.
- Personal loan – If you don’t have enough equity or aren’t willing to use your home as collateral, a personal loan might be an option.