There are a variety of different types of mortgage refinances. One specific refinance is a cash-out refinance, which helps homeowners get cash out of their home. However these refinances can be a bit complicated to understand, especially when it comes to the tax side of things. Understanding the tax implications of a cash-out refinance is important because you should be properly prepared before making such a big financial decision.
What is a Mortgage Refinance
A mortgage refinance is the process where an original mortgage is replaced by a new one. The new loan usually has updated terms or conditions that can provide the homeowner the opportunity to get a better interest rate, shorter loan term, and more. There is more than one type of refinance that a homeowner can choose. Some kinds of refinances are:
- Rate-and-Term Refinance
- Cash-Out Refinance
- Cash-In Refinance
This is what most homeowners think of when they think of a conventional refinance. With a rate-and-term refinance, the new mortgage will have an improved interest rate, and better loan terms. For example, if your credit score improved, then you may be able to lower your interest rate from 2.43% to 1.36%. This reduced interest rate can mean thousands in savings over the course of the loan. In this refinance, the new loan will be worth the remaining amount of the existing loan.
This is a popular refinance option for homeowners that want to get the most out of their home equity. As homeowners pay off their mortgage, they increase the amount of equity that they have. Sometimes when homeowners need a lump sum of cash, they may turn to their equity to provide these funds. In this refinance, instead of the new loan being worth the remaining original loan balance, it will be based on the amount of accessible equity.
When homeowners choose a cash-in refinance, they want to make some serious dents in the amount that they owe to the lender. With this type of refinance, the homeowner will provide additional funds during closing to reduce the amount that they owe to the lender. This can improve their overall loan-to-value (LTV) ratio which can show the lender that they are less of a risk.
Why is a Cash-Out Refinance So Special?
A cash-out refinance is special for a bunch of reasons. This is the only type of refinance that can provide homeowners the opportunity to tap into their home equity. However, this also means that there are tax implications that are associated with this refinance.
Understanding Tax Implications
A cash-out refinance can provide homeowners the opportunity to basically update their mortgage so that they can achieve a goal. Some homeowners want the funds of their cash-out refinance to go towards managing their debt. Others may need extra funds for an unexpected emergency. Regardless of the reason, the IRS sees these refinances as a tool to handle debt in one way or another. This means that the tax implications of a cash-out refinance will be less impactful than when you originally got your mortgage.
In 2017, the new Tax Cuts and Jobs Act impacted single and married filers when they increased the standard deduction. On top of that, this act also cut many of the deductions that homeowners used to be able to rely on. This updated tax law meant that there were a number of changes to the tax implications of a refinance.
Do You Have to Pay Taxes on a Cash-Out Refinance?
While cash-out refinances can have some tax implications, it is important to not get confused by them! A common misconception that homeowners have is that they will have to pay taxes on a cash-out refinance. Luckily, the funds that the borrower received are not considered a form of income. This means that the homeowner is not responsible for taxes on this type of refinance. The funds received are considered a loan.
Can I Deduct My Mortgage Interest After a Cash-Out Refinance?
Before you can think about deducting your mortgage interest after a cash-out refinance, you will need to make sure you have a clear understanding of what mortgage interest is.
What is Mortgage Interest?
Mortgage interest is simply the amount of interest that is charged on a loan, specifically in regards to a property (mortgage=property and interest=interest rate). The amount of interest is determined by the lender and can be either a fixed-rate or variable-rate.
What About a Mortgage Interest Deduction?
Now that you understand mortgage interest, it is time to understand what mortgage interest deduction means. When you get a cash-out refinance, you can deduct 100% of the interest, if the funds are used for a home-improvement project. However, if the funds aren’t used for home improvement projects then you will only be able to deduct a percentage of the interest paid on your original loan balance.
Does a Cash-Out Refinance Affect Property Taxes?
In order to determine the value of your home, during a cash-out refinance there will be an appraisal. This could have a ripple effect when it comes to your property taxes. It may be confusing to understand at first so please bear with us!
Property taxes are based on the value of the home. The official value of the home is determined by the local taxing agency based on your area. The amount of property tax due is updated periodically and varies depending on locality. Some places update property taxes every year, other places update property taxes every 3 years, etc.
When an individual goes through with a home purchase, then there will be an automatic reassessment of property taxes. While a refinance can seem very similar to the process of buying a home, it is different. This means that a cash-out refinance will not directly impact your property taxes based on the fact that it is a refinance, but it could still have an impact.
How Can a Refinance Still Impact Property Taxes?
The loan that you have will be a part of the public record because technically the property belongs to the lender until the loan is repaid. This means that since the assessor of property taxes can view the public record, they may see an increased home value. If the home value shows as raised, then this could lead to an increased assessment on property taxes which can make them more expensive.
Can You Deduct Refinance Closing Costs on Taxes?
When you get a cash-out refinance, you will be able to deduct most of the closing costs over the course of the refinance. For example, if your new mortgage repayment term is 15 years, then you can spread your deductions over the course of those 15 years.
How to Reap the Most Out of Your Cash-Out Refinance?
Getting the most out of your cash-out refinance can mean a world of difference. However, the way that you can actually reap the full benefits depends on a bunch of factors, and the biggest one is you. You don’t have control over much in life, but you do have control of yourself. That is why making sure you are properly prepared can mean that your refinance process not only goes smoothly but can be as beneficial as possible! Some ways that you can reap the most of your cash-out refinance include using the funds from your refinance towards home improvement projects.
Why Should You Use the Funds for Home Improvement?
A cash-out refinance is viewed as a loan in the eyes of the IRS. However, the interest rate from this loan can be considered tax deductible if they go into home improvements. Some popular home improvements include:
- A New Room Addition
- Add a Recreational Water Area
- Fix Your Roof
- Get Solar Panels
- Improve the Exterior of the Home
A New Room Addition
Adding a new room to your home can make your home instantly more attractive. Not only can it boost the value of your home, but this project is considered a tax-deductible home improvement. In fact, adding a new room could boost the value of the home by $30,000 to $50,000!
Add a Recreational Water Area
Do you like spending time in pools, jacuzzis, or spas? Well if your answer was yes, you’re not alone. Many Americans love having fun in the water. That is why this can be a great home improvement to consider. However, this home improvement is based on the area of the home! For example, if you live in a cold climate, then an outdoor pool may not make much sense. This is still considered a home improvement, which means it can be considered tax-deductible. Pools could improve the value of the home by 5% to 8%!
Fix Your Roof
Your roof is a very important component of the home. It takes a lot of beating over the years. Roofs are not indestructible and will need to be replaced at one point. Replacing a roof can be pricey. Luckily, this home improvement is considered tax-deductible and could improve the value of your home by an average of $15,427!
Get Solar Panels
Times are changing. More and more people are looking for energy efficient ways to not only save money, but be kinder to the planet. Going solar has a ton of benefits, like the fact that it can reduce your energy bill, improve the value of your home, etc. Many homeowners believe that going solar could hurt the value of their home but that’s not true! This tax-deductible option may be able to increase the value of your home by about 4.1% of the value of the home.
Improve the Exterior of the Home
There are plenty of ways that you can improve the exterior of your home and still have the project be considered tax-deductible. However, a popular option that people tend to choose is the addition of a fence. Not only can it look aesthetically pleasing, but it can also add an attractive layer of privacy to the home.
Mortgage refinances are a great opportunity to achieve financial goals like getting a more manageable monthly payment, getting cash out of your home, etc. There are a variety of refinance options, but if a homeowner wants to tap into their home equity then they will need to choose a cash-out refinance.
These refinances are a great option but there are some tax implications to be aware of before you choose this type of refinance. The interest rate from your cash-out refinance may be 100% tax-deductible, only if the funds go towards home improvement. Home improvements that are tax-deductible are:
- A New Room Addition
- Recreational Water Areas
- Replaced Roof
- Solar Panels
- Improved the Exterior of the Home
Cash-out refinances can be a bit complicated to understand. That is why you should talk to your lender to make sure you understand what a cash-out refinance means in terms of your budget, your taxes, etc.