Understanding the tax implications of a cash out refinance is a simple matter of understanding what the government taxes. We pay taxes on income and gains. A cash out refinance may seem like an income since it, by definition, gives you cash. However, it is, from a wealth perspective, at best a wash. Although you have more money in your pocket, you have less money stored up in your property. Since this does not qualify as income, no tax is due on the initial cash payment. Refinances, though, can have other tax implications.
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Reasons for Your Cash-Out Refinance
A cash-out refinance's effect on your taxes is directly dependent on what you will be doing with the money. If you are cashing out to improve your home, the new debt is considered "acquisition debt," and the interest on your mortgage is deductible on the first $1,000,000 or $500,000 of the mortgage's balance, depending on if you are filing as a married couple, or with some other status such as single or married-filing-separately. If you are taking cash out for other purposes, such as debt reduction, you can only deduct the interest on the first $100,000 of "home equity" debt.
Points and Costs
Any points involved in your refinance can be deducted over time, subject to them being allocated to either acquisition or deductible home equity debt. To figure out your annual deduction, divide the total amount that you spent on points by the loan's term (in years). For instance, if you paid two points to get a $200,000 30-year loan, your total cost would be $4,000. You would be able to write off $133 per year, until the loan was paid off.
Impact on Sale Basis
Bear in mind that taking money out of your property does not impact its tax basis. If a married couple bought a property for $100,000, held it for a number of years and sold it for $1,000,000, they would have a taxable capital gain of $400,000, after their $500,000 exclusion. Even if they had an $800,000 mortgage on the property at the time of sale, and only received about $130,000 after paying the loan and brokerage commissions, they would still have to pay capital gains taxes on the entire $400,000. This is where the fact that a cash-out refinance is not taxable can come back to bite owners.
Investment Property Exchanges
The tax-neutral nature of cash-out refinances can be useful for investors who are selling their property and buying more property through a 1031 tax-deferred exchange. Because these exchanges do not allow them to take any cash out of the sale and purchase transactions, going back after the fact to pull out cash is an excellent option. Investors considering this strategy should work closely with an accountant and tax lawyer who is well versed in 1031 exchanges to ensure that their timing complies with IRS regulations, which are in flux on this topic.