With a cash-out refinance, the homeowner can withdraw equity from their home. If your home is valued at $200,000 and you owe $150,000, you have $50,000 in equity. With a cash-out refinance, you can access your equity in cash and use it on whatever you like, from home renovations to paying off debt. But be aware that there are tax implications on a cash-out refinance.

Below is what you need to understand about how a cash-out refinance can affect your taxes. Talk to your tax professional if you have any questions about the tax implications of a cash-out refinance for 2021.

Tax Rules For Cash-Out Refinances

One of the benefits of a cash-out refinance is you can deduct the interest paid on your new home loan from your taxable income. However, with recent tax law changes, you can only deduct the interest from your tax return if the money is used for capital improvements on your property.

Capital improvements mean renovations that add to the value of the home, extend its longevity, or adapt it for a new use. It is smart to talk to a tax advisor to be sure the home renovation project you are doing qualifies for the tax write-off. It is on you to prove to the IRS that you used your equity for capital improvements, so hang on to receipts related to the project.

How To Use Cash-Out Refi Equity So It Is Tax-Deductible

There are many home renovations that qualify as capital improvements that you can do to claim the mortgage interest deduction. Some examples:

  • Add a swimming pool
  • Build a bedroom or bathroom
  • Put up a fence
  • Improve the roof to make it more effective in protecting from the elements
  • Replace windows with storm windows or energy-efficient windows
  • Install a new air conditioning system
  • Put in a security system

Remember that capital improvements for tax purposes are defined as permanent additions that boost the value of the home. Painting a room or fixing a window does not qualify.

Tax experts say that capital improvements must ‘substantially improve the home.’ Room additions, kitchen and bathroom upgrades, room additions, and home modifications to house an elderly parent would qualify.

Limits to Mortgage Interest Deduction with Cash-Out Refi

You cannot deduct the interest on your new home loan if you use the equity for anything other than a capital improvement. For example, you cannot write off the interest if you pay off consumer debt or buy a new car. In those situations, you only can deduct the interest on the original balance of the mortgage.

For example, say you have a home loan with a $60,000 balance. You want to pull out $20,000 in equity. If you use your equity to put in a swimming pool, you can deduct the mortgage interest on the full $80,000. If you use it to pay off your Discover card, you only can deduct the interest paid on the original balance of $60,000.

Other Limits to Mortgage Interest Deductions

You can only deduct the interest you paid on the first $750,000 if you are married filing jointly, and $375,000 if married filing separately. This rule applies to any loan used to buy, build, or improve the home.

Note that a cash-out refi replaces your old mortgage with a new, bigger one. It is not free cash. You get some of the difference between your current loan balance and the value of your home in cash. The new loan includes the amount you got in cash as well as closing costs. So it could go over the maximum you can claim under new tax laws.

The good news is you can deduct all of the mortgage interest on the original loan balance, even if it is over the limit. So, if you have An $800,000 home loan balance, take out $20,000 and use it for a new kitchen, you are allowed to deduct the interest on the $800,000, even though it goes over the $750,000 limit.

But you are not allowed to deduct the interest on the $820,000 because it is over the limit, even though you used it on a capital improvement.

What About Deducting Mortgage Points?

You cannot deduct the total amount you paid on points in the year you did your cash-out refinance. However, you can take smaller tax deductions throughout the life of the mortgage.

If you bought $2,000 of mortgage points on your 15-year cash-out refinance, you can deduct around $133 per year for the life of the loan.

Frequently Asked Questions

Below are common questions about how cash-out refinances affect taxes.

Q: How Does a Refinance Affect Your Tax Return?

A: If you refinance your mortgage to a new, lower rate, keep in mind that it can reduce your total tax deductions. You will pay less interest, which means you have less mortgage interest to write off on April 15.

Q: Do You Have To Pay Taxes on a Home Refinance?

A: You do not need to pay taxes on the money you receive in your cash-out refinance. The money is not considered income.

Q: Does Refinancing Affect Tax Return?

A: Refinancing your mortgage to a lower rate can reduce your total tax deductions because you are paying less interest. You will have less mortgage interest to write off at tax time.

Q: Can You Deduct Interest on a Cash-Out Refinance?

A: You can only deduct 100% of the mortgage interest if you use the money for a capital home improvement, such as a kitchen or bath remodel, room addition, and other major improvements. Talk to your tax advisor to be sure your capital improvement qualifies. And you cannot deduct the interest on a cash-out refinance if you use the money for other purposes, such as pay off debt or buy a car.

Q: Does a Cash-Out Refinance Count As Income?

A: No. The equity you receive in a cash-out refinance does not count as income for tax purposes.

Q: Will My Taxes Go Up If I Refinance?

A: It is possible that refinancing will reduce your tax deductions if you are refinancing to a lower rate than you had before. So, yes, your tax bill can increase as a consequence of some refinances.

Q: How Do I Claim a Refinance on My Taxes?

A: You can deduct any interest paid on a rate and term refinance if the loan is for your primary residence, and you itemize your tax deductions. If you are doing a cash-out refinance, you can deduct the interest on your original loan balance. However, you can only deduct the interest on the equity you pull out if you use it for a capital improvement, such as a kitchen or bathroom remodel, room addition, and other major improvements.

Tax Implications Summary

New tax laws have changed when you can deduct mortgage interest from your taxes on a cash-out refinance. You can deduct the interest on the equity you withdraw if it is used for a capital improvement. It is wise to check with your tax advisor to be sure that you are using the equity in a way that allows you to write off the interest.

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