Need access to a substantial amount of cash whether to pay for home upgrades, expand your portfolio, or even pay for education and medical bills? You may look at cash-out refinancing as a viable option.
Refinancing is a great tool to raise money by tapping into your home equity. And it is available to the majority of homeowners, not just the rich. Black Knight reports that the average U.S. homeowner had $216,900 in tappable equity in Q2 of 2022. Long-time property investors use this equity to snowball their investments by leveraging the equity they’ve built to buy another income-generating property.
Are there any tax implications for cash-out refinancing on rental property? Is the mortgage interest of a cash-out refinance tax deductible? These are reasonable questions first-time homeowners might ask. In this article, we’ll talk about these things in great detail. But first, let’s look at what cash-out refinancing is and how it works.
Cash-out refinance: How it works
A cash-out refinance is a type of mortgage refinancing that allows you to turn the equity you have in your home into cash. It involves replacing your current mortgage with a new one that has a larger balance. This is so you can take the difference in cash. Because of the nature of how this works, a cash-out refinance is ideal for properties that have gone up in value.
For example, you took a $200,000 loan for a $300,000 home. After many years of mortgage payments, you’ve built an equity of $200,000. Now, assume that the improvements you’ve made over the years coupled with market appreciation raised your property’s value to $400,000. A lender who agrees to refinance 75% of your property’s value will give you $300,000 in cash.
After paying off the remaining $100,000 from your old mortgage, you’ll still have $200,000 you can use for anything.
The most common uses of cash-out refinance include:
- Home improvements
- Buying another property
- Covering medical expenses
- Paying off debt
In general, a cash-out refinance is a useful way to access large amounts of cash by tapping into the equity you have built up in your home. Yet, it also comes with some risks and costs like higher mortgage payments and interest rates, closing costs amounting to 2-5% of the loan amount, or even foreclosure if you can’t keep up with the payments.
Tax implications of cash-out refinance on rental property
Since a cash-out refinance gives you access to large amounts of cash by restructuring your debt, many individuals ask if the money you get from a cash-out refinance is taxable.
Fortunately, the money you get from a cash-out refinance is nontaxable. This is because the IRS views them as an additional liability and not income. Thus, the $200,000 remaining cash from our example above will be received in full.
However, a cash-out refinance isn’t free money. Eventually, you’ll have to pay it back to your lender with the agreed-upon interest. The good thing is, the mortgage interest from a cash-out refinance can be deducted from your taxable income if used the right way.
How to get tax deductions from a cash-out refinance on a rental property
Although you can use the money from a cash-out refinance for any expense, the Tax Cuts and Jobs Act of 2017 placed a limit on what expenses are tax deductible. In general, you can no longer deduct the interest of your loan if the loan proceeds weren’t used to buy, build, or substantially improve your property.
Thus you can’t claim mortgage interest tax deductions if you use the proceeds to pay for personal expenses like high-interest debt, medical bills, or vacations. The best way to maximize tax deductions from a cash-out refinance loan is to reinvest it into your property or grow a rental property portfolio.
Here’s how to use cash-out refinance and get tax deductions.
Invest in capital improvements
Capital improvements are expenditures made to improve or add value to your property. These expenses are typically made to increase your property’s value or prolong its life.
Examples of these expenses include:
- Replacing the roof
- Adding a bedroom
- Renovating a bathroom
- Adding a home security system
- Adding a swimming pool
- Installing a central heating and cooling system
It’s important to note that capital improvement expenses for a rental property are different from repairs and maintenance expenses. Repairs and maintenance expenses are costs that are incurred to keep a property in good working order and are generally considered to be operating expenses.
Buy another rental property
Buying another rental property using the money from a cash-out refinance loan is not only a great way to deduct mortgage interest from your taxable income but also a great way to build your rental property portfolio.
Many investors use Build, Rehabilitate, Rent, Refinance, Repeat (BRRR) method in which the investor leverages the equity built on their properties to buy another rental property.
Other investors use the money from a cash-out refinance transaction as a downpayment to incur more debt and own a larger piece of real estate, thereby, a larger cash flow. If the proceeds from a cash-out refinance are used to buy a rental property, you can claim the mortgage interest as a tax deduction regardless of the method used.
Create a home office
If you used the proceeds from the cash-out refinance to build a home office in your primary residence, you can claim the mortgage interest as a tax deduction since a home office is considered a capital improvement.
Furthermore, adding a home office also has additional tax benefits. The IRS allows you to deduct a portion of your mortgage as a business expense if a portion of your property is used exclusively for trade or business.
The IRS has two ways of calculating the deduction amount.
- The simplified method allows you to deduct $5 per square foot for home offices less than 300 square feet.
- For home offices larger than 300 square feet, the regular deduction lets you deduct based on the size of your home office in relation to the rest of your home.
Other refinance costs you can claim as deductions
Mortgage points are interest discounts offered by lenders in exchange for an upfront payment. Basically, mortgage points are a way to buy down your interest rates.
These costs are tax deductible but you aren’t allowed to deduct the entire amount in the year you bought the mortgage points. Instead, you should spread the deductions over the course of the loan.
For example, if you’ve bought mortgage points amounting to $3,000 for a 30-year refinance, you can deduct $100 a year for 30 years from your taxable income.
Though mortgage points and property taxes are the only tax-deductible closing costs for your primary home, there are more tax-deductible closing costs for rental properties because the IRS sees the income generated by these properties as taxable income. This gives more leeway as to what expenses you can write off.
These costs can vary widely depending on the location and type of property, as well as the terms of the sale. In general, tax-deductible closing costs for a rental property may include:
- Attorneys’ fees
- Appraisal fees
- Refinance application fees
- Legal and recording fees
- Inspection fees
Refinancing your rental property is a great way to access capital for major expenses ranging from personal and emergency expenses to capital improvement and portfolio expansion. The money you get from refinancing your rental property is not taxable since the IRS views this money as additional liability and not income.
However, you cannot claim mortgage interest deductions for expenses not related to buying, building, or substantially improving a property. Hence, the best way to use the money from a cash-out refinance is to invest in capital improvement or buy another rental property.