If you’re planning a major home upgrade and want to use your home equity to your advantage, you might wonder about cash-out refinance tax implications. Many homeowners use this type of refinance to cover some expensive debt, like adding a pool or replacing a broken HVAC unit.
We’ll discuss some of the implications you might consider when you file your taxes during the year in which you take a cash-out refinance. We’ll also give you a refresher on how these refinances work and how much they cost so you can understand how the IRS views the money you receive.
You accept a loan with a higher principal and take out the difference in cash when you take a cash-out refinance. The IRS views refinances a bit differently than they do a first mortgage. In other words, the IRS sees refinances as a type of debt restructuring. This means that the deductions and credits you can claim with a refinance are less robust than when you originally took out your loan.
The Tax Cuts and Jobs Act of 2017 increased the standard deduction for both single and married filers but also cut many tax deductions homeowners could previously count on.
Under this tax law, your insurance payments aren’t considered tax deductible. Some new rules also apply to refinances. For example, you can’t deduct the total cost of any discount points you pay at closing in the year you get your new loan (above the $10,000 max property and state tax deduction). However, you may deduct them over the course of your new loan.
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It’s important that we review how cash-out refinances work before we look at how the IRS views the money you get from this transaction.
When you do a cash-out refinance, you replace your existing mortgage with a loan that has a higher principal balance. Your lender then gives you the difference in cash. You can use the money from a cash-out refinance for almost anything; however, many homeowners use it to consolidate debt or make home improvements.
Say you have $100,000 left on your mortgage loan and you want to do $30,000 worth of repairs. Your lender might offer a new loan worth $130,000 at a 4% annual percentage rate (APR). You take the refinance and your lender gives you $30,000 in cash a few days after closing. You then pay back your new mortgage loan over time, just like your old loan.
One of the first questions that many homeowners have when they take a cash-out refinance is whether they need to report the cash received as income when they file their taxes.
The cash you get from this kind of refinance isn’t “free money.” It’s a form of debt that you must pay interest on over time. The IRS doesn’t view the money you take from a cash-out refinance as income – instead, it’s considered an additional loan. You don’t need to include the cash from your refinance as income when you file your taxes.
In exchange for this leniency, there are a few rules on what you can and can’t deduct when you take a cash-out refinance. Though you can use the money for nearly anything, you’ll need to use it for a capital home improvement that increases the home’s value to deduct your interest. You usually can’t deduct the interest if you use the money for anything else, like paying off credit card debt or taking your dream vacation. IRS Publication 936 covers this in a little more detail.
Limitations have been set on what interest you can deduct when you take a cash-out refinance, and there are a few ways to claim refinance tax deductions. Let’s go over some of them now.
You can deduct the interest you pay on the portion of your loan that you refinance if you make a capital improvement in your home. Anything that adds longevity to your home, increases its value, or adapts the home to a different market counts as a capital improvement. Some of the most common capital improvements include:
Capital improvements can also include installing a home security system and other smaller improvements.
Remember, only home additions count as capital improvements. Home repairs don’t improve the baseline value of your property and don’t qualify for an interest deduction. This includes repairs like the following:
Improving the value of your property means you can also save money when you sell your home. Capital home improvements count toward the total amount you spent on the property and can potentially lessen your capital gains tax liability. Always keep careful records and receipts so you know when you did your renovations and how much money you spent.
Adding a home office is a capital improvement and allows you to deduct the cost of any interest you pay toward your cash-out refinance. A home office can also offer additional tax benefits if you’re a small-business owner or are self-employed.
You can claim the home office deduction on your federal taxes when you add a home office to your residence. The home office deduction allows you to claim a percentage of what you pay in your mortgage as a business expense. You may choose the simplified deduction or the regular deduction when you calculate your tax liability.
You’ll need to follow these rules:
Imagine that you add a 500-square-foot home office to your primary residence. This brings your total property size to 2,000 square feet. Let’s also imagine that you pay $1,500 a month for your monthly mortgage payment, own a small business and conduct your business primarily from the office you’ve added. You can deduct 10% of your monthly mortgage payment ($1,800 annually) from your federal taxes as a business deduction.
Keep in mind that in order to qualify for the home office deduction, you must meet some specific criteria:
You might use the money from a cash-out refinance to improve or repair a rental property that you manage. You can deduct these expenses from your federal taxes. Any improvements or repairs you make to a property you rent out are almost always tax deductible. This is because the IRS considers any money you earn from rent as personal income. You can also deduct closing costs, interest and insurance you pay on a rental property from your income as business expenses.
