A cash-out refinance gives you extra money that you can use to cover any expense. You can afford a vacation, make home repairs, or cover living expenses. While cash-out refinances offer flexibility, some people wonder how the IRS will view the transaction. The IRS has many taxes and complicated rules, so is your cash-out refinance also subject to taxation? This guide will cover how a cash-out refinance impacts your tax implications.
How Does a Cash-Out Refinance Affect Your Taxes?
A cash-out refinance’s impact on your tax bill depends on where you live. Each country has different laws, and this guide will explore U.S. tax law.
How Are Cash-Out Refinances Taxed in the United States?
The great news is that the IRS does not raise your taxes if you use a cash-out refinance to access additional equity in your property. The IRS treats a cash-out refinance as a loan restructure. The proceeds from a cash-out refinance do not count as income or capital gains, which means you are free and clear.
Overview of Taxes in Relation to Cash-Out Refinance
Taxes really don’t have much of an impact on your cash-out refinance. These are some of the common questions and what homeowners should know.
How Much You Can Borrow
Taxes don’t play much of a role in limiting how much you can borrow. The only exception is that mortgage lenders may not want to work with you if you are behind on your property taxes. Most lenders will require that you are up-to-date on your property taxes before you can request a cash-out refinance.
The more important limiters to keep in mind are your credit score and debt-to-income ratio. A higher credit score and a lower DTI ratio will give you more choices. Each lender has requirements for these metrics, and the requirements also vary for the type of loan. For example, it is easier to get an FHA loan than it is to get a conventional mortgage.
Do You Pay Taxes on Cash-Out Refinance?
You do not have to pay any taxes on your cash-out refinance. This rule also applies to HELOCs and home equity loans. The IRS does not treat loan proceeds as income.
Impact of Tax Laws on Cash-Out Refinance
You still don’t owe taxes on a cash-out refinance, but tax laws have impacted several components of the process, such as how much you can deduct from your taxable income.
The Tax Cuts and Jobs Act of 2017
The Tax Cuts and Jobs Act of 2017 increased the standard deduction but also limited how much homeowners could trim their taxable incomes with itemized deductions. A big change for homeowners seeking refinances is that you can no longer deduct the total cost of discount points. Instead of deducting them right away, you have to spread the deduction across the length of your new mortgage.
Recent Changes and How They Affect You
No longer deducting the entire cost of discount points right away is a significant change. Homeowners should also consider that they can only deduct interest payments if the loan’s proceeds go toward improving the property. For example, you cannot deduct interest if you use the loan’s proceeds to go on a vacation. However, you can trim your taxable income with interest deductions if you used the loan’s proceeds to improve your home.
Tax Implications of Cash-Out Refinancing
These are some of the tax implications of cash-out refinancing.
Mortgage Interest Deductions
You must use the loan to add value to your property if you want to deduct mortgage interest payments.
Home Equity Loan Tax Deductions
The same rule applies to home equity loans. You only get the tax deduction if you use the loan to invest in your home’s improvement.
Potential Tax Benefits and Drawbacks
You can get some interest deductions if you use the capital to add value to your property. However, there aren’t many notable tax benefits or drawbacks of using a cash-out refinance. If you use the funds to add a home office, you can use the interest as tax deductions. You will also score additional tax breaks since a home office opens the door for additional tax deductions.
The Role of Capital Gains in Cash-Out Refinance
You won’t get taxed right away if you use a cash-out refinance, but what about capital gains? Discover how a cash-out refinance impacts your capital gains.
Understanding Capital Gains and Losses
Capital gains and losses are taxable events. A capital gain occurs when you sell an asset at a higher price than you bought it. You will end up with a lower capital gains tax rate if you hold onto an asset for more than a year. Capital losses are tax deductions that reduce how much you owe. You can only incur capital losses if you sell an asset at a lower price than its cost basis.
Capital Gains Tax Rate and Cash-Out Refinance
A cash-out refinance can minimize your capital gains when it’s time to sell your property. A refinance increases your cost basis thanks to its closing costs. A higher cost basis reduces how much you owe in capital gains tax.
You can save a lot of money with a cash-out refinance if it allows you to keep your home instead of selling it. The IRS has rules in place to reduce capital gains taxes on primary residences, but those rules aren’t present for investment properties.
Tax Tips to Consider Before Opting for Cash-Out Refinance
A cash-out refinance won’t have much of an impact on your taxes. You can deduct interest payments if you use the loan to qualify for investments in your home. You will end up with a higher cost basis if you refinance your property.
Using a cash-out refinance to keep your home instead of selling it has two key benefits. The first benefit is saving on capital gains, but another advantage exists. When you pass away and give your house to your heir, the cost basis gets stepped up to the current market value. If you bought your home for $300,000 and it has since gone up to $1 million, you would incur significant capital gains by selling your property. However, if the property goes to your heir, that beneficiary inherits the property at a $1 million cost basis instead of the $300,000 cost basis that you paid to buy the house.
The step-up rule is a significant rule that allows wealth to be passed more easily from generation to generation. It applies to primary residences and investment properties. The step-up rule also extends to other assets like stocks. Step-ups happen regardless of whether you refinance or not. However, a cash-out can save you a lot of money if it’s the difference between selling your property and passing it on to your heir.
Conclusion: Making the Most of Cash-Out Refinance Taxes
You won’t have to worry about the IRS hovering around your proceeds if you get a cash-out refinance. You might be able to deduct interest, but it depends on how you use the money. Tax implications for a cash-out refinance are relatively small, but this route can shield you from the capital gains associated with selling your property.
FAQs About Cash-Out Refinance Taxes
You can do a cash-out refinance to avoid capital gains. You may be able to avoid selling your property with this financial product.
A cash-out refinance on a rental property is not a taxable event.
You can only deduct interest paid on a cash-out refinance loan if you use the proceeds to improve your property.
