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, or the difference between your current mortgage balance and the value of your home. If your home is worth $200,000, for example, and your current mortgage balance is $150,000, you have $50,000 in home equity.

With a cash-out refinance, you can access that equity in cash, and use it on 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. The larger, new one includes the balance of the current mortgage, the cash (equity) you received and any closing costs rolled into the new mortgage.

Because of this, the IRS doesn’t treat your cash-out as income, so you don’t need to pay income taxes on the money you receive. There are certain rules you must follow in order to claim the mortgage interest deduction, however.

Tax rules for cash-out refinances

You can deduct the interest paid on your new mortgage from your taxable income if you use the cash-out funds to make capital improvements on your home. Generally speaking, these include permanent additions and home improvements that increase the home’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 for capital improvements, 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:

  • Add a swimming pool or hot tub to your backyard
  • Construct a new bedroom or bathroom
  • Erect a fence around your home
  • Enhance your roof to make it more effective in protecting against the elements
  • Replace windows with storm windows
  • Set up a central air conditioning or heating system
  • Install 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 window or small design changes like painting a room don’t 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 deduct the interest you paid on only your original balance, or $60,000.

Using a cash-out refinance to pay off credit card debt may be the better move if you’re burdened by high-interest debt.

“The average credit card rate is around 16 percent and mortgage rates are sitting at around 3 or 4 percent,” explains DiBugnara.

It’s also important to note that there are other limits to mortgage interest deductions. You can deduct only the interest paid on the first $750,000, if married filing jointly, or $375,000, if married filing separately, of your mortgage. This rule applies to all loans used to buy, build or improve your home.

Remember, a cash-out refinance essentially replaces your current mortgage with a bigger mortgage, but it isn’t free money. You get some of the difference between your current mortgage balance and your home’s value in cash. Your new mortgage includes the amount you got in cash in addition to any closing costs, so it may breach the maximum amount you’re allowed to claim.

Fortunately, you can deduct all of the interest on the original balance, even if it’s above that limit. If you have an $800,000 mortgage balance, for example, and take $20,000 in equity through a cash-out refinance and use it for a capital home improvement, you can still deduct interest on the original balance of $800,000, even though it breaches the current limit. However, you cannot deduct the interest on the entire new balance of $820,000, because it’s above the current limit, even though you used it for a capital improvement.

The new limit was set by the Tax Cuts and Jobs Act, which went into effect in tax year 2018. Refinances originated before Dec. 16, 2017, fall under the old limit, which was $1 million for married couples filing jointly and $500,000 for married couples filing separately.

Keep in mind that if you claim the mortgage interest deduction, you can’t claim the standard deduction, which was doubled under the TCJA. Consult with a tax professional to see which option is best for you.

Deducting mortgage points on a cash-out refinance

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

With a cash-out refinance, you cannot deduct the total amount of money you paid on 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, you can deduct about $133.33 per year for the duration of the loan.

Risks of a cash-out refinance

In times of economic uncertainty and low interest rates, 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, with complex rules.

“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

Finally, 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). You can also do a traditional refinance, which replaces your mortgage for a new one with the same balance, but a lower refinance interest rate.

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