What are the tax implications of cashing in on a mortgage refinance?

A payment refinance allows you to withdraw your home equity, which is the difference between your current mortgage balance and your home’s value. For example, if your house is worth $200,000 and your current mortgage balance is $150,000, you have $50,000 in equity.

By paying to refinance, you can take the value of that equity and use it as a (relatively) low-interest loan to finance anything from home renovations or college tuition to medical bills. If you’re considering a payment refinance, be sure to read our payment refinancing guide and read on to learn more about the tax implications of doing so.

Are payment refinancings taxable?

No, your Cash Out Refinance earnings are not taxable. The money you get from paying a refinance is essentially a loan you take out of your home equity. Loan proceeds from HELOCs, home equity loans, cash refinances, and other types of loans are not included in income.

Not only do you pay no income tax, but you can even deduct some of the interest you paid to pay for the refinance. With the passage of the Tax Cuts and Jobs Act of 2017, the standard deduction increased significantly, and the mortgage interest deduction breakdown no longer makes sense for most claimants. However, if you set up a personal loan, you must follow special rules about how the loan proceeds will be used to earn the mortgage interest deduction.

Tax Rules for Cash Refinancing

If you use the funds paid to make capital improvements to your home, you can deduct the interest you paid on your new mortgage from your taxable income. Deductible items are usually permanent additions and conversions to increase the value of a property, extend its useful life, or adapt it to a new use. Consider seeking advice from a tax professional to ensure that the project you undertake is eligible. When filing your tax return, you’ll need to prove that you used the money in an acceptable manner, so keep receipts and other documents related to your project.

“If you can use that money to add value to your home, and you can write it off, that’s a double benefit,” said Ralph DiBugnara, vice president of Charlotte-based Cardinal Financial.

How to use your cash to refinance to make interest tax deductible

You can tackle many home improvement projects with a mortgage interest waiver payment. Here are some examples:

Add a pool or hot tub to your backyard
Build a new bedroom or bathroom
put up a fence around your house
Upgrade your roof to more effectively protect it from severe weather
update window
Set up central air conditioning or heating
Install a home security system
Remember, a capital improvement is usually defined as a permanent increase in the value of a home. Repairs such as repairing broken windows or small design changes such as painting a room usually do not count.

“Capital improvements must substantially improve your home,” explains Dennis Brager, a certified tax specialist with Los Angeles-based Brager Tax Law Group. “Kitchen and bathroom remodels, room additions, modifications for an elderly parent would all qualify. A standalone painting would not qualify; on the other hand, if it was just part of a larger remodel, then the cost of the paint job would qualify.”

Cash-out Refinance Mortgage Interest Deduction Limit

If you use the payment for anything other than principal improvement, you cannot deduct interest on the entire new mortgage. This includes paying off credit card debt or buying a new car. In these cases, you can only deduct interest from the original mortgage balance.

Let’s say you have $60,000 in principal on your mortgage and want to raise $20,000 in equity by paying a refinance. If you use the money to add a hot tub to your backyard, you can deduct the total amount of interest you paid, which is $80,000. If you use it to pay off credit card debt, you can only deduct the interest you paid and use only your original balance or $60,000.

That said, using cash to refinance to pay off your credit card debt is still a smart financial decision when you’re saddled with high-interest debt. Most credit cards charge double-digit rates, while mortgage rates have hovered in the 3% range since the pandemic began.

For 2018, some deductible limits have changed. A simplified version of the current rule: You can deduct up to $375,000 in mortgage interest if you’re single or married filing your taxes separately, or up to $750,000 if you’re married and filing your taxes jointly.

If you bought a house before the new limit took effect, you can still deduct interest on the higher balance, but this higher limit will not include any of your payments.

Deduction of Mortgage Points in Cash-Out Refinancing

Mortgage credits, also known as discount credits, are essentially upfront payments you pay the lender in exchange for a lower loan interest rate. One cent equals 1% of your mortgage.

With cash refinancing, you can’t deduct the full amount you paid for points in the year of the refinance, but you can make smaller deductions over the life of the loan. So, for example, if you purchase $2,000 worth of mortgage points for a 15-year refinance, you can deduct about $133.33 per year over the life of the loan.

Cash-out refinancing risk

Paying for a refinance can be a cheap way to borrow much-needed cash, but it also means you have to pay off a new, larger loan.

“The biggest tax risk is that you don’t meet all the strict rules about deductions, and you end up with a big surprise when you file your taxes,” Bragg said. “To avoid this, it’s best to talk to your tax advisor about your personal circumstances before making a commitment. The bigger risk is not tax risk, but not being able to pay your mortgage during tough economic times, and being overextended because of Lose your home.”

Alternatives to Cash Refinancing
Paying for a refinance isn’t the only way to get home equity. Consider a home equity loan or line of credit (HELOC), which is a second mortgage on your home. These options put your current primary mortgage in place. If you have a lower interest rate on your existing mortgage, now that interest rates have risen significantly, you can save money by borrowing only the amount you need.