Tax Implications of a Cash-Out Refinance

There are a lot of factors to consider before deciding if a cash-out refinance is a good financial move. Cash-out refinances replace your existing home mortgage, but tack on additional funds to the new loan that are paid out as cash to the borrower. People usually arrange a cash-out refinance when they want not only to obtain a more favorable home loan, but also to receive a lump sum of cash to use as they wish. But the proceeds from a cash-out refinance are not taxable as income.

Besides interest rates and the short- and long-term costs of a new home loan, also think about the cash-out refinance tax implications. Learn if cash-out refinances are considered taxable income, how you can get a tax deduction for one, and more.

Does a Cash-Out Refinance Create Taxable Income?

There are some cases in which getting an infusion of cash is counted as taxable income, such as taking a withdrawal from an IRA or cashing in bonds. But taking a cash-out refinance is not one of those times.

That’s because, although you benefit from receiving a lump sum of cash, the proceeds from a cash-out refinance are a loan, not income. You are borrowing from the equity in your home and have to pay that amount back over time, instead of taking money from an account that earned income. Therefore, you don’t have to claim the cash-out amount as income on your tax return.

How Refinancing Can Create Tax Deductions

In the past, one of the key benefits of home loan products such as a home equity line of credit (HELOC), home equity loan, or refinance was that you were allowed to take a tax deduction on the interest you paid, regardless of how the money was used. In other words, the IRS allowed you to get back some of the money you paid out on your tax return. However, the rules regarding home loan interest deductions changed in 2017. Now, you can only get tax deductions under certain circumstances.

Here’s what you may be able to deduct when you arrange a cash-out refinance.

Mortgage Points

Mortgage points, or discount points, occur when you pay money at the loan closing in exchange for a lower interest rate. For regular mortgages, points are deductible because they are considered prepaid interest. But with cash-out refinances, points are not fully deductible on your income taxes in the year they are paid; instead, the deduction is spread out over the life of the loan. However, you could get a partial tax deduction upfront if you meet specific parameters and decide to use the money for home improvements.

To qualify for this exception, you first must meet several IRS criteria (such as living in the home the loan is for, paying points being a standard business practice in your area, among others), and you must use your cash-out proceeds to make “capital improvements” to the home. If you meet those requirements, you can deduct a percentage of the points you paid.

Here’s how it works: Let’s say your loan is for $100,000 and you use 10% of it ($10,000) toward a home improvement project. In that case, you can deduct 10% of the points you paid from your taxes in the year you did the refinance. So if you paid $3,000 in points, your deductible amount would be $300. The other $2,700 in deductions would be divided evenly over the remaining years of the loan.

So, for instance, adding on a new room, replacing your roof, or putting in a fence or an in-ground pool would count; painting, basic repairs, or replacing appliances would not.

Interest

In order to take a mortgage interest deduction on your cash-out funds, you must use them for home improvement that increases the home’s value. In other words, if you decide to use the cash to pay off credit card debt, take a vacation, or other personal living expenses, then it would not qualify as tax-deductible.

How To Claim Tax Deductions for a Cash-Out Refinance

To claim tax deductions on a cash-out refinance, the first thing you’ll need to do is itemize your tax return. In other words, you must file Form 1040 or 1040-SR and itemize deductions on Schedule A. If you are taking the standard deduction, then you won’t be able to include any mortgage deductions.

Your lender will send you Form 1098, which shows how much you paid in mortgage points and mortgage interest. Give this form to your tax preparer.

Limitations To Interest Tax Deductions

In addition to its other changes, the TCJA placed a lower dollar limit on mortgages that qualify for the home mortgage interest deduction (beginning in tax year 2018 until 2026). Currently, taxpayers may only deduct interest on up to $750,000 of qualified residence loans. For married taxpayers filing a separate return, the limit is $375,000. (Prior to the act, limits were $1 million, or $500,000 for a married taxpayer filing separately.)

Frequently Asked Questions (FAQs)

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