A cash-out refinance lets homeowners replace their current mortgage with a larger one, giving them access to additional funds. This option can help fund home upgrades, consolidate high-interest debt, or handle other financial needs. However, it’s essential to understand how a cash-out refinance can impact your taxes. Although the money you receive isn’t considered taxable income, the way you use it could have tax consequences. Let’s dive into the details of what you should know.
Is a Cash-Out Refinance Taxable?
The great news is that the cash you get from a cash-out refinance is not considered taxable. The IRS views it as a loan, not as income, which means it doesn’t add to your taxable earnings. Since you’re expected to repay the refinance loan, there’s no need to report the funds as income on your tax return.
Does a Cash-Out Refinance Affect Taxes?
While the cash you receive isn’t taxed, a cash-out refinance can affect your taxes depending on how you use the funds. The key consideration is whether you use the money for home improvements or other purposes.
Interest Deductions on a Cash-Out Refinance
If you put the money from a cash-out refinance toward home improvements, you might qualify for interest deductions on the new loan. The IRS permits these deductions for loans used to purchase, build, or significantly enhance your property. For example, if you refinance your mortgage and use part of the funds to add a new room, you could potentially deduct the interest on that portion of the loan. The interest on your original mortgage balance (if it was used for home purchase or improvements) is also deductible.
However, you can only deduct the interest if the funds are used for eligible purposes. If you spend the money on non-home-related expenses, like paying off credit card debt, the interest on that amount won’t be deductible.
Restrictions on Deductions for Non-Home Improvements
For the 2018–2025 tax years, the IRS restricts deductions for interest on loans used for non-home expenses, like paying off consumer debt. So, if you take out a cash-out refinance and use part of the funds to pay off debts, you cannot deduct the interest on the portion of the loan used for that purpose.
For example, if you refinance and take out $75,000—using $50,000 for home improvements and $25,000 to pay off credit card debt—you can only deduct the interest on the $50,000 used for the improvements.
Mortgage Interest Deductions with Cash-Out Refinance
If you meet the requirements, you could deduct interest on the full loan amount, within certain limits. For single or joint filers, the IRS permits interest deductions on mortgage balances up to $750,000. For married individuals filing separately, the limit is reduced to $375,000 per person.
Here’s an example, if you refinance a $200,000 mortgage and take out an additional $50,000 for home improvements, you could potentially deduct interest on the full $250,000. However, if the $50,000 is used for something else (like paying off debt), the deduction applies only to the original mortgage balance.
Tax Benefits and Risks of a Cash-Out Refinance
A cash-out refinance can be a great way to access extra cash and potentially save on taxes, especially if you use the funds to improve your home. However, like any financial decision, it’s important to understand both the benefits and risks. Here’s a closer look at how a cash-out refinance can impact your taxes, and what to keep in mind before moving forward.
How Tax Benefits Work
You can potentially deduct mortgage interest as a key tax advantage of a cash-out refinance when you use the funds for home improvements. The IRS permits deductions on loans used to purchase, build, or significantly enhance your property. For example, if you take out a cash-out refinance to renovate your kitchen or add an extension to your home, you could qualify for an interest deduction on the amount used for those upgrades.
Here’s a scenario, if you refinance your mortgage for $250,000 and use $50,000 of that money to renovate your home, you could potentially deduct the interest on that $50,000. This can save you money on your taxes, especially if you’re itemizing deductions.
You can deduct the interest on up to $750,000 of your mortgage balance if you’re married and filing jointly (or $375,000 if filing separately), according to the IRS. This means you could reduce your tax bill if you use the borrowed funds for home improvements.
What About the Rest of the Loan?
If you borrow more money than you need for home improvements, only the interest on the portion used for your home will be deductible. For example, let’s say you refinance your home and borrow $75,000, using $50,000 for a home renovation and $25,000 to pay off debt. In this case:
- The interest on the $50,000 used for the renovation is deductible.
- The interest on the $25,000 used for paying off debt is not deductible.
This shows how important it is to plan carefully. If you want to make the most of your tax savings, you’ll want to use it for home improvements.
Risks to Consider
While a cash-out refinance can offer tax savings, there are some risks to keep in mind. The main risk is that you’re increasing the size of your mortgage, which means higher monthly payments. A larger loan can strain your finances if you don’t prepare for the extra responsibility. Missing payments could put your home at risk of foreclosure, as the loan secures it.
Also, if you don’t use the extra money for home improvements, you won’t get the tax deductions you were hoping for. This means that you might not see tax savings if you use it to pay debt or buy a car.
Alternatives to a Cash-Out Refinance
If a cash-out refinance isn’t the right option, alternatives like home equity loans or home equity lines of credit (HELOCs). These allow you to borrow against your home’s value without refinancing your primary mortgage. Each option has its tax implications and potential benefits, so it’s important to carefully consider your needs before deciding.
Understand the Tax Implications of Cash-Out Refinance
While the cash from a cash-out refinance isn’t taxable, how you use it affects whether you can deduct interest on the loan. Using the funds for home improvements allows you to deduct the interest. But using it for other purposes, such as paying down debt, eliminates the potential tax benefits. Always consult with a tax professional to ensure you’re making the most informed choice for your financial situation.