If you have equity in your home, a cash-out refinance can help you tap into that cash. You receive a large sum of money at the closing and pay it back with your regular mortgage payment each month. You can use this money as you see fit. A few examples of ways people use them include debt consolidation, home remodeling, and paying for large expenses, such as a car or college.
Usually when you receive a large amount of cash, though, Uncle Sam taxes it. Does this mean that the money you get from your home’s equity is taxable?
Luckily, the answer is ‘no.’ You don’t have to pay taxes on the money because it’s not earned money. Instead, it’s a loan that you pay interest on over the entire term. In fact, rather than getting taxed on the money you take out, you may be able to write it off as a deduction on your tax returns.
The IRS’s Stance on Cash-Out Refinance Income
As we stated above, you may put more money in your pocket, but you don’t have to pay taxes on it. The IRS does not require you to claim this income. This is because it’s not income. Instead, you shift your assets.
Whether you tap into the equity or you leave it alone, it’s still an asset. It’s just in a different form. If you don’t touch it, the money sits in your home. If you take it out, you have the cash in your hand to do with as you please. The bottom line is, though, that you never did anything to change your position. You don’t have any capital gains or higher profits. You simply liquidated money you had tied up in your home.
Take a Higher Tax Deduction
We touched on this a little bit, but it’s worth mentioning again. When you take a cash-out refinance, you take out a higher loan. A higher loan balance means more interest. You can write this interest off on your taxes. While it’s not going to help you get rich, it’s a way to decrease your tax liability and offset some of the cost of having the loan.
Paying Taxes When you Sell the Home
The one time that you will pay taxes on your income is when you sell the home. The IRS requires you to pay on your capital gains. However, you get the first $250,000 free if you are single. If you are married, the first $500,000 in capital gains is untaxed income.
Keep in mind, it doesn’t matter how many times you refinanced and took cash out of your home, the IRS will still calculate your capital gains based on the purchase price of the home. Let’s say for example that you bought your home for $150,000. Today, it’s worth $500,000. The IRS would say you have $350,000 in capital gains. It doesn’t matter if along the way you took cash out of the home. You could have as much as $500,000 in loans at the time of selling and you would still have capital gains of $350,000, of which $100,000 would be taxable. This is how your receipts of a cash-out refinance could become taxable.
The bottom line is that you won’t pay taxes on your cash-out refinance funds now. But, when you sell the home, you will pay taxes on those capital gains. Keep this in mind as you determine if a cash-out refi is right for you.