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What are the tax implications of a cash-out mortgage refinance?

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A cash-out refinance allows you to borrow from your home equity, which is the difference between your current mortgage balance and the total value of your home. For example, if your home is worth $200,000 and your current mortgage balance is $150,000, you have $50,000 in home equity.

With a cash-out refinance, you can access the value of that equity and use it as a (relatively) low-interest loan to fund anything from home improvements or college tuition to medical bills. However, this isn’t “free money,” and there are tax implications.

Basics of a cash-out refinance

A cash-out refinance replaces your current mortgage with a larger one, which will include the balance of your current mortgage, the value of the equity you’re taking out and any closing costs you decide to include in the new balance.

The IRS doesn’t treat your cash out as income, so you don’t need to pay income taxes on the money you receive, but there are certain rules you must follow in order to claim the mortgage interest deduction.

Tax rules for cash-out refinances

You can deduct the interest you pay on your new mortgage from your taxable income if you use the cashed-out funds to make capital improvements on your home. Deduction-eligible projects generally include permanent additions and home improvements that increase the property’s value, extend its longevity or adapt it for new uses. Consider consulting with a tax professional to ensure the projects you’re doing qualify. It’s up to you to prove you used the money in a way that qualifies when you file your taxes, so save receipts and other paperwork associated with your projects.

“If you’re using that money to increase the value of your home and you get to write it off, it’s a double benefit,” explains Ralph DiBugnara, vice president of Charlotte-based Cardinal Financial.

How to use your cash-out refinance money so it’s tax-deductible

There are plenty of home improvement projects you can tackle with your cash out in order to claim the mortgage interest deduction. Here are some examples:

  • Adding a swimming pool or hot tub to your backyard
  • Constructing a new bedroom or bathroom
  • Erecting a fence around your home
  • Enhancing your roof to make it more effective in protecting against the elements
  • Upgrading windows
  • Setting up a central air conditioning or heating system
  • Installing a home security system

Keep in mind that capital improvements are generally defined as permanent additions that increase the value of your home. Repairs like fixing a broken window or small design changes like painting a room don’t usually count.

“Capital improvements must substantially improve your home,” explains Dennis Brager, a certified tax specialist with Los Angeles-based Brager Tax Law Group. “Kitchen and bathroom remodels, room additions, modifications for an elderly parent would all qualify. A standalone painting would not qualify; on the other hand, if it was just part of a larger remodel, then the cost of the paint job would qualify.”

Limits to the mortgage interest deduction with a cash-out refinance

You cannot deduct the interest on the entire new mortgage if you use the cash out for anything other than a capital improvement. That includes paying off credit card debt or buying a new car. In these cases, you’d only be able to deduct the interest on the original mortgage balance.

Let’s say you have a mortgage with a $60,000 principal, and you want to take out $20,000 in equity through a cash-out refinance. If you use the cash to add a hot tub to your backyard, you can deduct the interest you paid on the total balance, or $80,000. If you use it to pay off your credit card debt, you can only deduct the interest you paid on only your original balance, or $60,000.

Even so, using a cash-out refinance to pay off credit card debt can still be a smart financial decision if you’re burdened by high-interest debt. Most credit cards charge double-digit interest rates, while mortgage interest has been in the 3 percent range since the start of the pandemic.

In 2018, some of the deduction limits changed. The simplified version of the current regulation: You can deduct interest on up to a $375,000 mortgage if you’re single or married filing separately, or on up to a $750,000 mortgage if you’re married filing jointly.

If you purchased your home before the new limits went into effect, you will still be able to deduct interest payments on a higher balance, but that higher limit will not include any of your cashed-out funds.

Deducting mortgage points on a cash-out refinance

Also called discount points, mortgage points are essentially upfront fees you pay a lender in return for a lower interest rate on your loan. One point equals 1 percent of your mortgage loan.

With a cash-out refinance, you cannot deduct the total amount of money you paid for points during the year you did the refinance, but you can take smaller deductions throughout the life of the loan. So if you purchase $2,000 worth of mortgage points on a 15-year refinance, for instance, you can deduct about $133.33 per year for the duration of the loan.

Risks of a cash-out refinance

A cash-out refinance can be a cheap way to borrow much-needed cash, but it also means a new, larger loan you need to pay back.

“The biggest tax risk is that you fail to meet all of the stringent rules surrounding deductions, and you wind up with a big surprise at tax time,” Brager says. “To avoid this, it is best to speak with your tax advisor about your personal circumstances before you make a commitment. The even bigger risk is not a tax risk, but that in tough economic times, you are unable to make payments on your mortgage, and you lose your home because you are overextended.”

Alternatives to a cash-out refinance

A cash-out refinance is not the only method of accessing equity in your home. Consider a home equity loan or a home equity line of credit (HELOC), which are second mortgages on your home. These options leave your current primary mortgage in place.

Learn more:

Written by
Zach Wichter
Mortgage reporter
Zach Wichter is a mortgage reporter at Bankrate. He previously worked on the Business desk at The New York Times where he won a Loeb Award for breaking news, and covered aviation for The Points Guy.
Edited by
Mortgage editor