Do you own a portion of your home? That’s to say, do you have equity built up in the property? Equity is the portion of your home you can say is truly yours because it’s paid off, comparative to what’s left of your mortgage principal.
If you’ve ever conjured up thoughts of refinancing to tap into that equity, you’re not alone. Most Americans pull cash out of their home to consolidate debt. Many of them have no idea of the tax implications if they do.
Any time you’re dealing with money, you need to consider Uncle Sam. When you file your taxes after taking a cash-out refinance, it’s no different.
Taxes and Your Mortgage
As a homeowner, you’re likely very aware of the mortgage interest deduction. According to NerdWallet, it’s a tax deduction for interest paid on the first $1 million of mortgage debt. For many of us who never reach that million-dollar threshold, it’s a claim we can itemize on our tax return every year. (For homeowners who bought their house after Dec. 15, 2017, the threshold is $750,000 of the mortgage).
Generally, the same tax deductions are available when you refinance a mortgage as when you’re taking out your mortgage. But things change when you file your taxes during the year you take a cash-out refinance. That’s because it means you’ve accepted a loan with a higher balance (or principal) and you took out the difference between the old and new balance in cash.
The Internal Revenue Service will look at a cash-out refinance (or even a standard refinance) as debt restructuring. In turn, any deductions and credits you might be eligible for are less prosperous than when you originally took out the loan.
So, How Exactly Do Cash-Out Refinances Work?
As mentioned above, a cash-out refinance occurs when you swap your existing mortgage for a loan with a higher principal balance. A few days after closing, your lender then gives you the difference between those two numbers in cash.
The good thing about a cash-out refi is that you can use the money for pretty much anything. Many homeowners use it to consolidate high-interest debt by paying down credit cards or putting money back into the house by making repairs and home improvements.
If you’re still confused about how a cash-out refinance works, consider this:
Say you have $200,000 left on your mortgage loan, a home worth $320,000, and you want $40,000 of that equity to make repairs. Your new loan would be worth $240,000. You walk away with the cash and then pay back the new mortgage loan over time, just like the old loan.
Not surprisingly, one of the main questions homeowners have after a cash-out refinance is if they need to report the money as income on their taxes.
How the IRS Views a Cash-Out Refinance
The IRS doesn’t look at the money you get from a cash-out refinance as income. That means you don’t need to include any of that lump sum when you file your taxes.
For example, let’s say that you earn $70,000 a year after taxes as shown on your W-2 (or the form reporting wages paid by your employer and taxes withheld). You take a cash-out refinance of $40,000. One can argue you’ve technically earned $110,000 for the year, but the IRS still considers your income to be $70,000.
In exchange for this loophole, the IRS has put rules in place on what you can and cannot deduct from your cash-out refinance. Essentially, IRS Publication 936 says you need to use the money for a capital home improvement in order to deduct it from your interest. In other words, you need to make some kind of improvement to your home that will increase its value in order to qualify for the deduction. If you use the money for something else, such as paying off debt or going on vacation, there is no deduction.
Using Your Cash So It’s Tax-Deductible
While there are limits on what you can deduct interest from when you go through a cash-out refi, there are ways to use the money that are tax-deductible. As previously mentioned, that includes capital improvements on your home.
According to House Logic, a capital improvement is anything that increases your home value (which means you need to add on or replace, not repair, which just returns something to its previous condition).
Some of the more common capital improvements include:
- Finishing the basement
- Adding an addition
- A new master suite
- A new roof
- The addition of a porch, garage, deck, or patio
By IRS rules, capital improvements need to last for more than one year and add value to your home or adapt it for new uses. A full list of eligible improvements can be found in IRS Publication 523.
With that being said, capital improvements aren’t limited to elaborate and costly projects. They also include:
- A new HVAC system (central air-conditioning system or heating system)
- New windows
- Added insulation
- A home security system
- Built-in appliances
Keep in mind as you work to improve the value of your property that home repairs will not qualify for an interest deduction.
Remember that only additions count as capital improvements. That’s because home repairs don’t improve the baseline value of your property.
These would include:
- Fixing or replacing a broken window
- Fixing a leaking pipe
- Filling holes or cracks
- Replacing broken or dated hardware (such as knobs or handles on cabinets)
According to Quicken Loans, one of the most overlooked capital improvements is the addition of a home office. This will allow you to deduct the cost of any interest paid toward a cash-out refi, and can offer other tax benefits to those who are self-employed or small-business owners.
If you add a home office, you can also claim the deduction on your federal taxes. It means you can claim a percentage of what you pay on your mortgage as a business expense.
As you transition from a cash-out refinance to making capital improvements, remember to keep receipts and records to track your renovations and spending.
Final Thoughts on Cash-Out Refinance and Tax Implications
If you’re still considering a cash-out refinance to tap home equity, remember what you’ve read here — it’s not considered income by the IRS. You need to keep in mind any limits on tax deductions you might think you’ll be eligible for when you refinance your loan. Put your money toward capital improvement of your property to make the most of it, including any additional deductions you might be eligible for.
Finally, consult a tax advisor who can clear up any confusion and answer any questions you might have. Refinancing can help manage your tax liability and provide various opportunities to save money, but an expert can help you stay on the right track and make sound financial decisions.
- Mortgage Interest Deduction: What Qualifies in 2020? Nerd Wallet. Accessed at https://www.nerdwallet.com/blog/mortgages/mortgage-interest-deduction/
- Mortgage Refinance Tax Deductions, TurboTax. Accessed at https://turbotax.intuit.com/tax-tips/home-ownership/mortgage-refinance-tax-deductions/L2fzA7hg5
- About Publication 936, Home Mortgage Interest Deduction. IRS. Accessed at https://www.irs.gov/forms-pubs/about-publication-936
- Publication 523, Selling Your Home. IRS. Accessed at https://www.irs.gov/pub/irs-pdf/p523.pdf
- Can You Claim Tax Breaks For Capital Improvements on Your Home? House Logic. Accessed at https://www.houselogic.com/finances-taxes/taxes/tax-breaks-capital-improvements-your-home/
- A Guide to the Tax Implications of a Cash-Out Refinance. Quicken Loans. Accessed at https://www.rocketmortgage.com/learn/cash-out-refinance-tax-implications