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What Are the Tax Implications of a Cash-Out Refinance?
A cash-out refinance is a tool available to homeowners who have already built up equity in their homes. Unlike a traditional refinance, this type of loan leaves you with money in your pocket for expenses such as debt consolidation or home improvements.
If you’re thinking about a cash-out refinance, there are some considerations and tax implications you’ll want to keep in mind. Educating yourself on the rules of this type of mortgage ensures there are no surprises when your closing day and tax time roll around.
Cash-out refinance basics
When you refinance a mortgage, you essentially take out a new loan to replace your existing mortgage. Homeowners often refinance to lower their monthly payments or reduce their mortgage interest rates.
A cash-out refinance works a bit differently than most. Rather than taking out a new loan just big enough to cover your existing mortgage, you take a larger loan, reduce your equity in the home, and take cash for the additional amount.
Let’s say you own a home worth $300,000. You have $150,000 of equity in the home and still owe another $150,000. With a cash-out refinance, you might take out a new loan for $200,000. $150,000 goes to pay off your existing mortgage, while the other $50,000 goes into your bank account.
People might use a cash-out mortgage for a variety of reasons, including to consolidate debt or pay for home improvements. When the economy is struggling, people may also opt for a cash-out refinance to help stay afloat on bills, especially given the attractively low current interest rates.
[ More: The Best Refinance Mortgage Lenders ]
Tax on a cash-out refinance
The federal government does not consider the money from a cash-out refinance to be income because the money isn’t actually yours to keep. It’s a loan that you’ll have to pay back with interest. In fact, the interest you pay on that money may even be tax-deductible.
Tax-deductible expenditures you can use your refinance cash on
When you take out a new mortgage, the interest you pay is tax-deductible, but the rules work a bit differently for a cash-out refinance. You can’t deduct all of the interest you pay. Instead, you can only deduct interest on the portion of the cash you spend on home improvements that increase the value of your home (aka capital improvements).
Eligible capital improvements include:
- Adding a bedroom
- Adding a bathroom
- Putting in a swimming pool
- Adding or upgrading central air conditioning or heating
- Replacing windows
- Putting in a fence around your yard
It’s important to note that only home improvements, not home repairs, allow you to deduct the interest you pay on your refinance cash.
Drawbacks of a cash-out refinance
Cash-out refinances sound like a great deal. After all, who doesn’t like more money in their bank account? That being said, there are some disadvantages to this type of loan. Here are some things to consider:
- Closing costs: As with any other home loan, you’ll have to pay closing costs when you opt for a cash-out mortgage. You’ll have to ask yourself whether it’s really worth it, given these extra expenses.
- Loss of equity in your home: After a cash-out refinance, you have less equity in your home. This could result in having to pay private mortgage insurance (PMI) or ultimately losing money if you sell your home before rebuilding your equity.
- Risk of foreclosure: As with any mortgage, failing to pay back your loan could result in foreclosure. If a cash-out refinance increases your monthly mortgage payment, examine your budget and make sure you’ll be able to pay the money back.
- New loan terms: A new loan means new loan terms. If you’re doing a cash-out refinance because you need the cash, you risk ending up with a higher refinance rate or additional fees.
Alternatives to a cash-out refinance
Depending on your reasons for pursuing a cash-out refinance, there may be other alternatives to consider.
Home equity line of credit (HELOC) or home equity loan
Home equity loans and lines of credit both involve you borrowing money against your home, reducing the amount of equity you hold. A home equity loan is a one-time sum of money you borrow, while a home equity line of credit is a revolving debt that you can borrow and pay off repeatedly, much like a credit card.
Like a cash-out refinance, these types of loans give you money when you need it, but reduce the amount of equity you have in your home.
[ More: The Best Home Lines of Credit ]
A personal loan is an amount of money you borrow with the promise to pay it back over a certain number of years. Personal loans are usually unsecured, meaning there’s no collateral backing them up. The advantage of this type of loan is that you don’t risk losing your home if you fail to pay back the loan. But because they’re unsecured, these loans usually have much higher interest rates than mortgages.
If you’re refinancing your mortgages to get a lower interest rate, you may decide to go with a traditional refinance without cashing out any of your equity.
Discount or mortgage points
When you refinance your mortgage, you may also opt to buy discount points. This process involves giving your refinance company more money upfront for a lower interest rate. In other words, you’re buying down the rate.
Like some of the interest you pay on your cash-out refinance, any discount points you buy may also be tax-deductible. Rather than deducting the full amount in the year during which you refinance, you spread the deduction out over the life of the loan, just as you would have if you had paid the higher interest rate. Let’s say you take out a 20-year refinance loan. If you buy $2,000 worth of discount points, you would deduct $100 per tax year.
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