“Cash-out refinancing can be an excellent financial move. It provides homeowners with an opportunity to obtain lumpsum cash funds by liquidating some part of their home’s equity. Although homeowners can apply these borrowings for almost any purpose they wish, the associated interest costs may or may not be tax deductible. This article covers a comprehensive guide about tax on refinance cash out and how cash-out refinancing affects your taxes. Learn how the IRS treats proceeds from a cash-out refinance and what are the tax implications of a cash-out refinance.”
Homeowners cannot deduct interest costs on all expenditures made from cash-out refinance borrowings from their taxable income. Hence, understanding tax on refinance cash out is important.
It is important for homeowners planning to obtain some extra lumpsum cash funds by way of cash-out refinance to first understand the concept of tax on refinance cash out and its implications. This is because homeowners cannot deduct interest costs on all expenditures made from cash-out refinance borrowings from their taxable income. Hence, knowing the tax implications of a cash-out mortgage refinance can help homeowners derive maximum benefits from this financial move.
Basics of a cash-out mortgage refinance – A quick review
Before moving forward with our main topic – “tax on refinance cash-out”, it would be good to review the basics first.
A cash-out refinance is a mortgage refinancing tool to convert home equity into cash funds. The way cash-out mortgage refinancing works is that a homeowner replaces their current outstanding mortgage with a larger one.
The new mortgage or cash-out refinance includes the current outstanding mortgage amount, liquidated portion of the home equity, and closing costs. With a cash-out refinance, eligible homeowners can borrow lumpsum cash funds up to 80 percent of their home equity.
Home equity reflects the interest held by homeowners in their home. It is calculated as the difference between the current market value of a home and any outstanding mortgage on it. The value of home equity increases over time as the value of the property appreciates and/or as the homeowner makes further payments towards the outstanding amount of the mortgage.
Besides converting home equity into some extra cash funds in lumpsum, cash-out refinance serves other purposes as well. Many homeowners will opt for a cash-out refinance to secure a loan with better and more favorable terms. For example, getting a lower interest rate than what you are currently paying.
Cash out refinance example
Understanding cash-out refinance is straightforward with the help of the following example.
Suppose you bought a home with $250,000 in mortgage. After some payments, your current outstanding mortgage amount stands at $150,000. Now, if your home currently values $300,000, you have $150,000 in home equity ($300,000 which is the current home value less $150,000 which is the outstanding amount of mortgage).
An eligible homeowner can access a part of this home equity ($150,000 in our case) as lumpsum cash funds.
Understanding tax on refinance cash out
To better understand our main topic “tax on refinance cash out”, it is important to understand two key concepts.
First, to know whether the IRS considers cash funds from cash-out refinancing as taxable income or not. In other words, whether the cash-out refinance creates a taxable income for the homeowner or not.
Second, to understand the tax implications of a cash-out refinance. This means knowing the circumstances and situations in which the interest costs on cash-out refinance may or may not be allowed tax deduction.
Does the cash from a cash-out refinance become a taxable income?
To begin with, it is important to know how the IRS treats the cash received through a cash-out refinance. This means knowing if the IRS (Internal Revenue Service) considers the cash proceeds from a cash-out refinance as taxable income or not.
So, a quick answer to questions like, “is a cash-out refinance taxable?” or “are cash proceeds from a cash-out refinance subject to income taxes” is – No.
This is because the IRS does not consider cash proceeds received from cash-out refinance as income. Hence, a homeowner does not need to pay income taxes on funds obtained through a cash-out refinance.
Rather than treating cash from cash-out refinance as income, the IRS considers these funds as a loan that require repaying the lender over time. In reality as well, a cash-out refinance merely works as a tool to borrow funds against home equity built over time and not as an income source.
Despite the above, the IRS does allow mortgage interest on cash-out refinance to be deducted from taxable income. However, this requires following certain rules as to where the cash funds from cash-out refinance are used.
Our next section under the current heading presents a detailed analysis of the tax implications of a cash-out refinance. It explains how certain expenditures out of funds from cash-out refinance may or may not be tax deductible.
Rules for tax on refinance cash out – How do interest costs on cash-out refinancing become tax deductible?
Before December 2017, interest costs on funds obtained through a cash-out refinance were allowed tax deduction irrespective of how they were used. This means that the IRS allowed a tax deduction of all interest costs on cash-out mortgage refinance for a homeowner without considering their use or purpose.
However, the rules related to home loan interest deductions from the taxable income of a homeowner changed in 2017. Under the changed rules, interest costs on cash-out refinance are only allowed tax deduction under certain circumstances.
After 2017, the interest cost on funds borrowed through a cash-out refinance is allowed tax deduction only if the borrower uses the borrowings to make capital improvements to their home. This means that if a borrower uses cash-out refinance for personal purposes then interest costs aren’t tax deductible.
Examples of personal expenditures include taking a vacation, buying a car, paying off credit card debts, or paying college tuition. Moreover, it also includes making minor improvements and changes to fix, repair, or maintain a home but which do not count as capital home improvements. In simple words, homeowners cannot deduct interest costs on all such expenditures from their taxable income.
What is a capital improvement or home improvement project?
Another key aspect to understand about tax on refinance cash-out is knowing what is considered a capital improvement. Remember that many expenditures related to improving, fixing, adding, removing, and/or maintaining a home that any homeowner would normally consider as an upgrade, do not fall within the scope of a home improvement project or capital improvement on a home.
Hence, understanding the meaning of a capital improvement is necessary to learn whether an interest cost is tax deductible or not. Here is a simple explanation of what exactly a capital improvement or home improvement project means.
A capital improvement on a home is an addition or alteration to a real estate property that meets all the following three conditions –
- It causes a significant increase in the home’s value. Moreover, it also extends the useful life of the property and enables it to serve new and better purposes.
.. - The addition or alteration made forms part of the home or becomes permanently attached to it. This is clear from the fact that any subsequent attempt to remove the capital improvement from the home could result in material damage to the home or the home improvement itself.
.. - Last, the capital improvement project is done with the intention to make it a permanent addition to the home.
Cash-out refinance related interest costs on expenditures that aren’t considered capital improvements cannot be deducted from taxable income.
Some examples of capital improvement projects allowed as a tax deduction
Remember that the main purpose behind capital improvement projects is to add value, prolong useful life, and significantly improve the condition of a home. Hence, basic repairs and minor fixes such as painting kitchen cabinets, doors, and windows, changing appliances, or fixing a broken door or window do not count as a capital improvement.
The following list has some examples of capital improvement projects that are tax deductible in the case of a tax on refinance cash out.
- Building a swimming pool or installing a hot tub in the backyard
- Adding a new bedroom or increasing the number of ensuite facilities (bathrooms) in the home
- Upgrading the roof
- Putting up a fence around the property or home
- Installing a home security system
- Setting up or upgrading the air conditioning and heating systems
Once again, keep in mind that not all upgrades added to a home are considered as capital improvements. Similarly, interest costs on expenditures that aren’t considered capital improvements cannot be deducted from taxable income.
Additional aspects of tax on refinance cash out
The general guideline as mentioned above about tax on refinance cash out allows tax deduction only for interest costs related to capital improvements. However, there are a few other aspects of tax on refinance cash out as well. These other implications of tax on refinance cash out include –
- Deducting mortgage points
- Maximum limit of the mortgage interest deduction
- Impact of property taxes and any other local taxes
Let us now discuss each of these in detail.
1. Deducting mortgage points
Mortgage points, also called discount points, are upfront fees that the borrower pays to a lender at the loan closing. The purpose of this is to secure a lower interest rate on the loan. Normally, one discount or mortgage point is equal to one percent of the mortgage loan.
Unlike regular mortgages, mortgage points treatment in the case of a tax on refinance cash out is different. With regular mortgages, discount points are treated as prepaid interest and hence allowed a full deduction in the year of purchase.
But mortgage points in the case of a tax on refinance cash out aren’t fully tax-deductible in the year of refinancing. Rather, discount points are tax deductible in smaller amounts evenly spread over the entire loan term.
For example, a borrower bought $3000 worth of mortgage or discount points on a 15-year cash-out refinance. In this case, the borrower is allowed to deduct $200 ($3000 divided by 15 years) per year during the 15-year term of the cash-out mortgage refinance.
Partial tax deduction of mortgage points upfront – An exception
What is discussed above is a normal case of evenly deducting mortgage points from taxable income over the loan term. However, there is an exception to this rule as well. This exception combines mortgage points, tax on refinance cash out, and capital-home improvements – all three together.
With this exception, a qualifying borrower may get a partial tax deduction of mortgage points upfront. In other words, this means deducting more mortgage points in a year than what is normally the case otherwise.
However, for this exception to work, the borrower first must qualify for it. This means that the borrower meets several specific parameters as set out by the IRS and must also use the cash funds from the cash-out refinance to make capital improvements to the home. A borrower meeting these IRS requirements is allowed to deduct a percentage of the points paid.
The following example clearly explains how partial tax deduction of mortgage points upfront works in tax on refinance cash out. For a better understanding, we are continuing with the above example about discount points.
A borrower obtains a cash-out refinance loan of $200,000. Out of this loan, he uses 10 percent or $20,000 of it on a capital home improvement project. Based on this, the borrower is allowed a tax deduction in the year of refinancing, of the same percentage of tax points paid which again is 10 percent in this case.
Taking from the first example above, the borrower bought or paid $3,000 in mortgage points. Hence, he is allowed to deduct $300 (10% of $3,000) from his taxes in the year of refinancing. As for the remaining $2,700 worth of discount points, they can be evenly distributed over the remaining 14-year loan term.
2. Maximum limit of the mortgage interest deduction
Another important consideration in tax on refinance cash out is the maximum limit on the mortgage interest deduction. This means that there is a dollar ceiling or maximum limit of the mortgage loan amount on which interest costs can be claimed for a tax deduction. Taxpayers cannot claim interest costs on any mortgage amount beyond this maximum limit.
Persons, either single or married but filing separate tax returns, can claim interest costs deduction from their taxes for a mortgage loan amount up to $375,000. This mortgage limit doubles and extends up to $750,000 for a married couple filing tax returns jointly.
3. Impact of property taxes and any other local taxes
Lastly, it would be wise for a homeowner to consider the impact of making capital improvements on their property taxes. This means that the implications of tax on refinance cash out affect property taxes and local taxes as well.
For instance, the definition of capital improvement includes any addition or alteration to the property that significantly increases its value. Hence, if a home’s value increases because it underwent a capital improvement project, its property tax amount might also increase. Similarly, this could also happen for any other local taxes as well.
Consequently, a capital home improvement project could result in a taxpayer having to pay more in property taxes than before.
Final thoughts
To avoid getting hit by a surprise tax on refinance cash out, it is recommended to consult and seek advice from a tax expert first. Since every person’s situation is different, evaluating the various options available to you can be difficult without professional assistance.
At Attorneys Funding Group, our team of experts and professionals have decades of experience in dealing with issues related to tax on refinance cash out. Our consultants can help you navigate through various options available in your case with great comfort and ease.
Whether it is about understanding what qualifies as a capital improvement project for tax on refinance cash out or working out with mortgage points, we are here to help.
Call us now at (916) 471-2678 or click here to book a free consultation session and discuss your mortgage needs with one of our expert loan officers.
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