One option you have when refinancing your home is to take a cash-out refinance. This means you borrow more money than you currently owe on your mortgage. You can then take that money and do what you want with it. Some people pocket it, while others use the funds to fix up their home. No matter how you use it, there’s one question – is it taxable?
The good news is that the money is not taxed. The IRS does not look at the money as income. Here’s why:
Let’s say you have a current mortgage balance of $150,000. Your home is worth $300,000. So you have assets worth $300,000, but your net worth is actually only $150,000 because of the $150,000 debt.
Now let’s say you take a cash-out refinance for a total of $200,000. You now have $350,000 in assets and $200,000 in debts. Your net worth is still $150,000. You did not make anything on the deal. In other words, there weren’t any capital gains.
Writing Off the Interest
Another aspect of your taxes pertaining to your new mortgage is the interest you pay. Generally, you can write off mortgage interest on your first loan. You were probably doing just that with your current loan unless you didn’t itemize your deductions.
Now, what happens when you take out a larger loan? You are paying more interest, can you write it off? Generally, the answer is ‘yes,’ but there are some things you must consider. If you take the money out and invest it right into your home, meaning you fix it up, add a room, or do any type of work to the home, then you can deduct all of the interest.
But, if you don’t use the cash to fix up your home, you may end up only writing off a portion of the interest. Generally, you can write off the interest on the funds used to pay off your existing mortgage plus, the interest on the next $100,000. Any money you took beyond the $100,000 cannot count as an interest deduction.
Selling Your Home
There is a time when taking the cash out of your home does affect your taxes, though – when you sell the home. The IRS allows you to pocket capital gains up to $250,000 for single homeowners and $500,000 for married owners. But, there’s a catch. They use the original purchase price as the baseline. It doesn’t matter how much money you owe now or how much cash you have taken out of the home while you lived there.
Your capital gains are based on the current value of the home versus what you paid for it. You then subtract the $250,000 or $500,000 tax-free capital gains you are allowed. If there is anything money left over, you have to pay taxes on that amount, whether you realized it at the sale or not. At some point down the road, you realized those gains.
This is when a cash-out refinance can become taxable. You won’t pay the taxes right when you take the money. However, you will likely pay them when you sell the home, so make sure you prepare yourself for that situation.
The bottom line is that your cash-out refinance proceeds might become taxable one day. It depends on when you sell the home and how much you make on it. If you make more than $500,000 as a married couple or $250,000 as a single person, you will owe taxes at some point. It won’t be when you take the cash-out refinance, but further down the road when you sell the home.