Homeowners

Do You Pay Taxes On Cash-Out Refinance?

Understanding the financial effects of a Cash-Out Refinance is essential. One question that often comes up with homeowners is whether they must pay taxes on the money they receive from it. The short answer is no; the money you receive from a Cash-Out Refinance is not taxable. However, there are certain circumstances under which you could be liable for taxes. Read on to learn more. An experienced Loan Officer, like at New American Funding (NAF), can also help guide you through the process.

Cash-Out Refinance Overview

A Cash-Out Refinance is a financing method that allows homeowners to tap into their home equity by refinancing their current mortgage for a more significant sum of money. The homeowners receive the difference between the new and original mortgage in cash and can use it as they wish.

Is Cash-Out Refinance Taxable?

Contrary to popular belief, the cash obtained from a Cash-Out Refinance is not considered income by the IRS and is not subject to income tax. It's not income because the money is essentially a loan - you’re using your home equity. That means you're borrowing against the equity in your home, and you don't have to report it on your tax return. There are circumstances where you can even save in taxes, but there are also certain cases where you could be liable for taxes.

What Are the Tax Implications of a Cash-Out Refinance?

The tax implications of a Cash-Out Refinance primarily hinge on how you use the funds. There are potential tax benefits to Cash-Out Refinancing and specific circumstances where you can earn tax deductions or owe.

Can You Get a Tax Deduction From a Cash-Out Refinance?

In these scenarios, you could potentially get a tax deduction when you use the money in the following ways:

• Make substantial home improvements - Homeowners can claim tax deductions on mortgage interest if they use the cash to make substantial improvements to their homes that increase the property's value. For instance, renovating a rental property or adding a home office could provide tax savings opportunities. It's important to note that not all upgrades are considered capital improvement by the IRS.

• Purchase mortgage points - Homeowners who purchase mortgage points during the Cash-Out Refinance could potentially have an additional tax-deductible expense. Mortgage points, or discount points, are fees paid directly to the lender at closing in exchange for a reduced interest rate.

• Add a home office - Homeowners who use the funds to create a designated workspace in the home could potentially write off a portion of the mortgage interest, property taxes, and even utility bills as business expenses. However, there are specific rules to qualify for this deduction.

You Could Be Liable For Tax Deductions When:

There are certain circumstances under which you could be liable for taxes, including these potential scenarios:

• Profits from home improvement exceed the tax-free limit - The money from the refinance is used to substantially improve your home, increasing the home's value and the potential capital gain when you sell the house. If the profit exceeds the tax-free limit the IRS sets, you may have to pay capital gains tax.

• Deducting interest on the money that you don't use for home renovations - The Tax Cuts and Jobs Act of 2017 changed the rules, allowing homeowners to deduct the interest on mortgage debt up to $750,000, but only when they use the money buy, build, or substantially improve the taxpayer's home that secures the loan.

• The home sells for a profit - In this case, you may owe capital gains taxes. However, if you've lived in the home for at least two of the last five years before selling, up to $250,000 of the profit (or $500,000 if you're married and filing jointly) is tax-free.

Tax laws are complicated and can change, so consult with a tax professional to make the right choice for your financial situation.

Making Your Cash-Out Refinance Tax Deductible

A potential benefit of a Cash-Out Refinance is the possibility of tax deductions when you use the funds for eligible purposes, like improving your home or adding a home office.

Making Capital Improvements

Making capital improvements is one way to increase your chances of tax deductions because it adds value in the case of resale. Improvements like:

• Adding a swimming pool - provides enjoyment and a sense of luxury and potentially increases the home's resale value.
• Adding a fence - enhances the aesthetic appeal, increases privacy, and adds security.
• HVAC Replacement - new systems reduce energy consumption making it more cost-efficient.
• Adding a new room - adds usable square footage to the home.
• Upgrading the kitchen - improves functionality and energy-efficient appliances, saves money, and increases market appeal.
• Installing energy-efficient home appliances or equipment - reduces energy usage and cuts down costs on utility bills.

Setting Up A Home Office

Using Cash-Out Refinance funds to set up a home office could also make you eligible for tax deductions. That's because it's a capital improvement that increases the value of your property. There are strict regulations around what constitutes a home office, though.

IRS Guidelines To Claim A Home Office

• You use the space exclusively and regularly for business. Using it exclusively means not using the area for any other purpose, such as a playroom or a bedroom.
• The office must be the principal place of business. If you have another office outside your home where you conduct most of your business, the IRS will not consider your home workspace a home office.

Expenses and Deductions

If your home office setup meets the IRS criteria, you can deduct expenses related to the business use of your home. These deductions could include:

• Mortgage interest
• Insurance
• Utilities
• Repairs

When using funds from a Cash-Out Refinance to set up your home office, you can deduct the portion of the mortgage interest directly proportional to the office's square footage about the whole house. Similarly, you can deduct a percentage of your utility bills, such as electricity and internet, based on the office's size.

Alternatives to Cash-Out Refinance

While a Cash-Out Refinance can be beneficial, other alternatives are also worth exploring. Here are three options to explore, all with potential advantages, disadvantages, and tax implications.

1. Home Equity Loans - A Home Equity loan is a type of second mortgage that allows homeowners to borrow against the equity they have built up in their homes. Borrowing this way can provide substantial money for capital improvements or other significant expenses.

The interest rates for Home Equity loans are typically lower than those for personal loans or credit cards, making them a financially attractive option. However, the downside is that your home serves as collateral, meaning if you default on the loan, you risk losing your property.

2. Personal Loans - Personal loans are another alternative. Unlike Home Equity loans, personal loans don't require putting up your home as collateral. Not having to put your home up for collateral can be a safer option if you're uncertain about your ability to repay the loan. However, the interest rates on personal loans are typically higher than those on Home Equity loans or Cash-Out Refinances so they might cost more in the long run.

3. Saving and Budgeting - The old-fashioned approach of saving and budgeting requires discipline and patience. It's the least risky. By setting aside a certain amount of money each month for your project, you avoid needing loans and associated interest payments.

Each of these alternatives has potential tax implications; the best choice will depend on your circumstances and needs. A Loan Officer at NAF can help you understand the steps to refinance your home and help you decide which loan may be right for you.

FAQ's

Can You Avoid Capital Gains Tax by Refinancing?

Refinancing your home does not directly affect your capital gains tax. Capital gains tax applies when you sell an asset for more than you bought, like property or stocks. Refinancing is simply changing the terms of your loan, not selling the property. However, taking cash out during refinancing and using it to improve your home may reduce the potential capital gains when you sell your home.

When Is a Good Time to Do A Cash-Out Refinance?

The best time to consider a Cash-Out Refinance is when interest rates are low, your home's value has increased significantly, or you need a large sum of money for major expenses like home renovations, debt consolidation, or large purchases. Considering your financial situation and plans is essential, as refinancing can extend your repayment period and increase your total interest cost.

How Often Can You Refinance Your Home?

Technically, there's no limit to how often you can home refinance. However, you may have to pay closing costs each time you refinance, which can add up over time. Also, lenders may have restrictions, such as requiring a specific time to pass between refinances. Base your decision on whether the benefits, like a lower interest rate or cash-out, outweigh the costs.

Do Taxes Go Up When You Refinance?

Refinancing your home does not typically increase property taxes, as your home's assessed value determines taxes, not your mortgage. However, if you use a Cash-Out Refinance to fund significant home improvements, the value of your home may increase, potentially leading to higher property taxes. The value varies by area, so consulting with a tax professional or your local tax assessor's office is best.