How does a cash out refinance affect taxes?

On the heels of the holiday season is another well-known “season” – tax season.

Tax season begins soon, and you can never start preparing too early. If you are one of the millions of homeowners who took advantage of low interest rates in 2020, take note, there could be implications for your taxes, particularly if you took on a cash-out refinance loan.

What is a cash-out refinance?

A cash-out refinance is when you take out a new mortgage for what your home is worth, and the lender gives you the difference between the home value and your mortgage balance in cash.

Essentially, it is a way to liquidate your home equity and turn it into cash. You can then use this cash for pretty much any purpose: debt consolidation, home improvement, college tuition, starting a new business, or buying a second residence. And this cash comes at a rock-bottom interest rate that you pay off when you pay your mortgage each month.

IS CASH-OUT REFINANCING A GOOD IDEA?

How do I qualify for a cash-out refinance?

It is important to pay attention to loan qualification criteria, as not everyone qualifies for a cash-out refinance. Namely, you may not have enough equity in your home to be eligible for this option.

Here is what most borrowers need in order to qualify:

• At least 20% equity in your home.
• The ability to meet traditional mortgage prequalification such as healthy debt-to-income ratio, a good credit score, and steady income.

You can also plug the numbers into a mortgage refinance calculator.

For example, if your home appraises for $400,000, in most cases you’ll need a current loan balance of 80% of the value (that’s around $320,000 or lower) in order to qualify for a cash-out refinance. Some lenders will go up to 90%, but for most 80% is the threshold.

PERSONAL LOAN OR HOME EQUITY LOAN: WHICH IS BETTER?

What are the tax implications of a cash-out refinance?

There are certain considerations to make regarding tax deductions if you opt for a cash-out refinance. Here are some popular questions about tax implications that you need to know.

Is a cash-out refinance taxable income?

Getting a cash infusion via a mortgage refinance won’t change your taxable income or make you subject to any type of capital gains tax. But the cash from a loan refinance isn’t free money – you’re still paying it off as a loan each month when you pay your mortgage.

In that sense, the money from a cash-out refinance can’t be counted as taxable income. There are, however, certain tax deductions you’ll lose depending on how you use the money and this can impact your bottom line.

EVERYTHING YOU NEED TO KNOW ABOUT MORTGAGE REFINANCE

How to make a cash-out refinance tax-deductible

The short answer here is that in order to continue being able to deduct mortgage interest on your taxes, you have to use the cash-out monies to improve the value of your primary residence. Repairs (like replacing a hot water heater or repairing the HVAC system) do not count, but if you do anything to improve the home -- renovate and upgrade the kitchen and/or bathrooms, add a bedroom, or create a swimming pool -- then the mortgage interest can be used as a deduction.

Anything else, such as paying off high-interest debt or paying college tuition, would make your mortgage ineligible for the mortgage interest deduction, and depending on the size of your loan, this could cost thousands in mortgage interest deductions.

HOW TO GET THE BEST MORTGAGE REFINANCE RATES

Is it a good idea to do a cash-out refinance?

In order to make the most of a cash-out refinance option, think through the following first:

• First, assess how you’re going to use the cash from the refinance.
• Then, depending on the goal, ascertain if a cash-out refinance is truly the best fit. Other products, like a personal loan or student loan refinance, may make more sense if debt consolidation is the ultimate goal.
• Visit an online marketplace like Credible to review refinance rates and shop interest rates with multiple lenders in one spot.

If you’ve got a substantial amount of equity in your home, it may feel like a pretty sweet deal to be able to turn that asset into cash with just a small amount of paperwork. As with most financial decisions, however, it’s best to leverage refinance calculators to do the math and ensure the money moves actually improve your financial life, before signing on the dotted line.