A cash-out refinance lets you 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 and your current mortgage balance is $150,000, for instance, that means you have $50,000 in home equity.
Getting a cash-out to refinance allows you to access that equity in cash and use it on home-improvement projects, college tuition, medical bills, and other necessities. Bear in mind, however, that it isn’t free money, and they’re also are tax implications. Here is some detailed information to help you better understand exactly what you’re getting into when you obtain a cash-out mortgage refinance.
The basics
A cash-out refinance replaces your current mortgage with a larger one. The new larger mortgage includes the balance of the current mortgage, cash (equity) you received, and any additional closing costs. Because of this, the IRS doesn’t treat your cash-out as income, which means you aren’t required to pay income taxes on the money you receive. However, there are certain rules you must follow to claim the mortgage deduction.
Tax rules
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. These typically include permanent additions and improvements to the property that increases its value, extend its longevity, or adapt it for new uses. Always consult with a tax professional to ensure that the projects you’re undertaking 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.
Available deductions
There are plenty of home improvement projects you can tackle with your cash-out to claim the mortgage interest deduction. Among them: adding a pool or hot tub to your backyard; building a new bedroom or bath; erecting a fence around your home; enhancing the roof to make it more effective when it comes to protecting against the elements; and replacing windows with storm windows. You also can use the cash-out to set up a central air-conditioning or heating system and install a home security system. Remember that capital improvements usually are defined as permanent additions that increase the value of your home. If you’re fixing a window or making small design changes like painting a room, that doesn’t count.
Limits on deductions
If you use the cash-out for anything other than a capital improvement—like paying off credit card debt or buying a new car—you won’t be able to deduct the interest on the entire new mortgage. You only would be able to deduct the interest on the original mortgage balance. For example: If you have a mortgage with a $60,000 principal, and you want to take out $20,000 in equity through a cash-out refinance, you can deduct the interest you paid on the total balance (or $80,000) if you use the cash to add a hot tub to your backyard.
If you use it to pay off your credit card debt, you can just deduct the interest you paid on your original balance, or $60,000. In addition, you only can deduct the interest paid on the first $750,000 of your mortgage if you’re married and filing jointly or $375,000 if you’re married and filing separately. This rule applies to all loans used to buy, build, or improve your home.
Fortunately, you can deduct all of the interest on the original balance, even if it’s above that limit. For instance, if you have an $800,000 mortgage balance and take $20,000 in equity through a cash-out refinance to use for a capital home improvement, you still can deduct interest on the original balance of $800,000 although it breaches the current limit. However, you can’t 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 the 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 new tax law. Consult with a tax professional to see which option is best for you.
Deducting mortgage points
Also called discount points, mortgage points primarily are the up-front fees you pay a lender in return for a smaller interest rate on your loan, with one point equaling 1 percent of your mortgage loan value. With a cash-out refinance, you can’t 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.
The risks
In times of economic uncertainty and low-interest rates, a cash-out refinance can be an inexpensive 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 failing to meet all of the stringent rules surrounding deductions and then ending up with a huge surprise at tax time. To avoid this, you should discuss your personal circumstances with your tax adviser before you make a commitment. The even bigger danger is not a tax risk: If you’re unable to make payments on your mortgage, you could wind up losing your home because you are overextended.
Alternatives
Lastly, a cash-out refinance is not the only method of accessing the equity in your home. You can get a home equity loan or line of credit (HELOC). You also can do a traditional refinance, which replaces your mortgage for a new one with the same balance, but a lower refinance interest rate.
