What's in this article?
You can take full advantage of your home equity by determining how taxes on cash-out refinance loans can benefit you.
Cash-out refinancing is a loan type that allows you to exchange your existing mortgage for a new loan. This new loan can give you access to the cash you’ve paid into your home.
It can be a great way to finance improvements, pay off higher-interest debt, or invest in projects requiring significant funds.
But what are the tax implications that come with a cash-out refinance? Understanding possible tax complications are important to ensure you’re making the most of the money you receive.
In this article, we’ll cover everything you need to know about paying taxes on cash-out refinance.
Introduction to cash-out refinancing
Cash-out refinancing enables you to replace your existing mortgage loan with a new one and then receive the additional cash based on your home’s equity.
This additional cash is considered “cash out” since you’re taking out more than you originally owed. The additional cash can be used for a variety of purposes, including home improvements, debt consolidation, and more.
This new loan pays off the old one with a different interest rate, principal, and term.
Depending on how much money you’ve paid into your original mortgage and the current value of your property, you can opt to receive the difference in cash. You’re essentially taking out a loan against the equity of your home.
It’s a big financial venture, so it’s important to understand the implications of taxes on a cash-out refinance and be aware of any deductions you might be able to use.
Want more personalized rates?
Get customized rates tailored to your individual mortgage needs.See Today’s Rates
Does a cash-out refinance generate taxable income?
No—the funds you get from a refinance are not considered “free money”—it’s a form of borrowing on which you will pay interest.
The Internal Revenue Service generally does not see the funds you receive through a cash-out refinance as income, so you don’t need to declare it when filing your taxes.
However, certain regulations should be considered when taking out a cash-out refinance. The funds may be used for virtually any purpose, yet the interest you pay can only be deducted if the money is utilized for a capital home improvement.
To be able to deduct interest, the funds must be used to make some advancement to the residence that increases its worth. If the money is used to satisfy other expenses, such as settling credit card debt or vacationing, the interest usually cannot be deducted.
How to use deductions to maximize your cash-out refinance
When you receive a cash-out refinance, the IRS restricts certain interest deductions. However, there are a few ways to reap the benefits of refinancing tax deductions.
Raise home value through improvement projects
The interest on the portion of your mortgage you refinance can be deducted if you make a capital improvement in your residence—something that adds to the lifespan, and marketability, or boosts the worth of your home.
These capital improvements might include the following:
- Adding a swimming pool, spa, or hot tub to the backyard
- Installing a fence for personal and aesthetic purposes
- Constructing a new bedroom or extension to the home
- Reinforcing the roof for greater longevity
Improvements don’t have to be large-scale projects to qualify as capital improvements. Here are a few examples of more minor upgrades:
- Swapping out an existing central air-conditioning or heating system
- Setting up a home security system
Note: Only improvements made to a property that increases its baseline value can be considered. Basic home repairs often do not count as capital improvements and do not qualify for an interest deduction.
Examples of home repairs that generally do not qualify for an interest deduction include:
- Fixing an HVAC system
- Replacing a defective or broken window
- Giving your bedroom a fresh coat of paint
Also, remember to save documentation and receipts of your renovations and the amount of money spent on the property.
Tax benefits of using cash-out refinance for a home office
Making a home office is another type of capital improvement, and it may allow you to deduct the cost of interest you pay toward your cash-out refinance.
Furthermore, a self-employed person or a small-business owner could also gain other tax advantages from having a home office.
When you incorporate a home office as a part of your home, you can use certain home office deductions on your federal taxes, including a portion of your mortgage payments as a business expense.
According to the IRS, if your home office is no bigger than 300 square feet, you can take advantage of the simplified deduction and get a $5 per square foot reduction from your federal taxes.
For an office larger than 300 square feet, you are eligible for a regular deduction based on the office size ratio to your total mortgage cost.
Like most tax deductions, be aware that certain qualifications must be met to be eligible for the home office deduction.
A requirement is that the home office is employed solely for professional tasks and that only the proprietor and their customers can be present in the space. It typically won’t count if the home office is utilized as a guest room or a child’s play area.
Main business location
Your home office must be the principal place where business is conducted. Even though it is not required that business be done exclusively from the office, it must be where the majority of the work, invoicing, and accounting is done.
Taxes on cash-out refinance—the bottom line
Today, homeowners everywhere are using cash-out refinance to access their home equity to finance home improvements, pay off higher-interest debt, or invest in other projects.
When it comes to taxes and a cash-out refinance, it’s important to consult your own tax or financial advisor and understand the implications of any deductions.
Fully utilizing and comprehending the tax implications surrounding your cash-out refinance can ensure that you’re making the most of the money you receive.
Reach out to one of Homefinity’s many experienced and dedicated loan officers if you have any questions regarding refinancing.