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Money borrowed with a cash-out refinance won't be taxed as income. The IRS treats this money as debt restructuring, not earned income.
This isn't the only good news for taxpayers who are considering a cash-out refinance to tap their home equity. Interest paid on the new cash-out loan may be tax deductible, which means it could possibly lower your taxable income.
Whether you can write off interest paid on a cash-out loan depends a lot on how you use the equity and how you file taxes.
Cash-out refinance basics
A cash-out refinance replaces your existing mortgage with a larger loan. The larger loan is big enough to pay off an existing mortgage and still leave leftover money for the homeowner to spend on other projects.
Let's say you owed $200,000 on your mortgage and your house is worth $400,000. You may be able to get a new $300,000 loan to pay off the $200,000 mortgage. The additional $100,000 borrowed can be spent elsewhere.
This cash from equity can be used to improve your home, pay off other debt, pay college tuition, or cover any other need.
How you use the money helps the IRS determine how much, if any, of the new loan's interest is tax deductible.
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Is a cash-out refinance taxable?
Even if you get $50,000, $100,000, or more in cash back, this money shouldn't be counted as income from the IRS's point of view.
A bigger question centers on whether mortgage interest paid to the lender can be deducted from taxable income each year.
The answer may be yes: If you use your cash-out funds to pay for qualifying home improvements you can potentially deduct the interest paid on your mortgage balance each year.
But what counts as qualifying home improvements? We'll dig deeper later in this post, but kitchen renovations, bathroom additions, new HVAC systems, or structural upgrades usually qualify.
But before we move forward, a disclaimer: Tax laws are complex and vary by individual situations. Consult a qualified tax professional to determine exactly how a cash-out refinance may affect your unique tax scenario.
What cash-out expenses aren't tax deductible?
Spend your cash-out funds on credit card payoffs, vacation costs, or education expenses, and you can deduct only part of the interest paid on the loan. Specifically, you can deduct interest paid on the part of the loan used to finance the home purchase refinance.
Let's say you refinance from a $200,000 mortgage into $280,000 loan, cashing out $80,000 in home equity. If that $80,000 pays for a new kitchen, you can deduct interest paid on the full $280,000 loan balance.
If you used the $80,000 to pay off credit card debt or to make a down payment on a rental property, only interest paid on $200,000 of the loan balance can be deducted.
Limits on how much you can deduct
Most of a mortgage loan's monthly payment goes toward interest during the early years of the loan, so this tax deduction can be significant, especially for borrowers with high loan balances.
The IRS limits this benefit. You can deduct interest on mortgage debt up to:
- $750,000 for homes purchased after Dec. 15, 2017
- $1 million for homes purchased on or before Dec. 15, 2017
- Half these amounts if married filing separately
If you plan to write off interest from a cash-out loan, you'll need Form 1098 from your lender or loan servicer. You'll also need receipts and invoices from contractors to prove money from the loan paid for home improvements, allowing the full interest deduction.
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More about qualifying improvements
Not all home improvements qualify for the mortgage interest deduction. The IRS says home improvements must increase property value, extend the home's useful life, or adapt it for new purposes.
Whether you can deduct interest is not always an all-or nothing question. You could spend part of a cash-out refi's proceeds on qualifying home improvements and part on non-qualifying projects. Then, interest on the part of the loan that financed qualifying improvements would be tax deductible.
Let's take a closer look at what improvements should qualify for the tax deduction:
Home additions and structural upgrades
Permanent structural changes to the home usually qualify for the deduction. This includes:
- Room additions: Adding bedrooms, bathrooms, or expanding living areas.
- New construction: Building garages, decks, or outdoor structures.
- Major systems: Installing new heating, cooling, or security systems.
- Swimming pools and hot tubs: Permanent installations that boost property value.
- Roofing upgrades: Complete roof replacement or major structural improvements.
These improvements typically add substantial value. A bathroom addition could increase your home's worth by $15,000 to $25,000, while a swimming pool could add $20,000 to $40,000 depending on your market.
Energy-efficient upgrades
Energy improvements qualify for deductions and often provide ongoing savings:
- Windows and doors: Upgrading to energy-efficient models
- Insulation improvements: Adding or upgrading insulation throughout the home
- HVAC systems: Installing new furnaces, air conditioners, or heat pumps
- Solar installations: Adding solar panels or energy storage systems
These upgrades can reduce your monthly utility bills while qualifying for tax benefits.
Home office construction
Creating a dedicated workspace opens multiple tax opportunities. Your home office must be:
- Used exclusively for business purposes.
- Your main place of business or regular client meeting space.
Business owners can potentially claim both the mortgage interest deduction and the home office deduction, allowing additional write-offs for utilities, insurance, and maintenance proportional to the office space.
What doesn't qualify for deductions?
"Qualifying home improvements" is a broad definition, but it doesn't include everything, The IRS won't allow interest deductions for cashed out equity spent on:
Repairs and general maintenance
Routine upkeep doesn't qualify for mortgage interest deductions, even when funded through your cash-out refinance. Fixing broken appliances, repainting walls, patching roof leaks, or addressing plumbing issues fall into this category.
While these tasks maintain your home's condition, they don't substantially boost its value or extend its useful life.
The IRS treats these as standard homeownership expenses rather than capital improvements. Even major repair projects—like replacing a failing HVAC system with an identical unit—typically don't qualify unless you're upgrading to a significantly better system as part of a broader renovation.
Short-term upgrades with no lasting value
Temporary or cosmetic changes rarely qualify for deductions. Trendy décor items, removable fixtures, seasonal landscaping, or minor aesthetic updates don't meet IRS standards. To qualify, improvements must permanently impact your property's value or functionality.
The enhancement must become an integral part of your home. Swapping out light fixtures might not qualify, but installing a whole-house lighting system with smart controls could. The key distinction: permanent integration versus temporary modification.
Money spent on a different home
You could use money from a cash-out refinance to make a down payment on a second home or to finance a fix-and-flip or a rental property. But money spent on other real estate won't qualify for the mortgage interest tax deduction. This deduction is designed for primary residences.
Rental property has its own set of tax advantages and liabilities, though. Check with a tax professional if you'd like to learn more.
Key questions about cash-out refinance tax implications
Should I choose a cash-out refinance over other options?
Cash-out refinancing works best when you can get a lower interest rate than your current mortgage or when you're planning substantial home improvements. Your monthly payment could increase since you're borrowing more against your home's equity.
Homeowners who want to keep their existing mortgage but still borrow cash from equity can use home equity loans and home equity lines of credit (HELOC). This type of borrowing adds a second mortgage payment each month rather than paying off the first loan. However, home equity loans tend to come with higher interest rates than cash-out refinances.
Since home equity loans and lines of credit usually have smaller balances, their closing costs are often lower than the closing costs on a cash-out refi. Their tax implications and rules work a lot like cash-out refi tax rules.
What about the points I paid on my cash-out refinance?
Discount points paid to lower the rate on a cash-out refinance work differently than those on purchase mortgages. You can't deduct the full amount in the year you paid them. Instead, you'll spread the deduction over your loan's entire term.
For example, if you paid $3,000 in mortgage points on a 20-year refinance, you can deduct $150 annually throughout the loan period. Keep detailed records of these payments for accurate tax filing.
What expenses don't qualify for tax deductions when using cash-out refinance funds?
General repairs and maintenance, personal expenses like debt repayment or tuition, and short-term upgrades with no lasting value will not qualify for tax deductions. This includes activities like repainting, fixing appliances, or paying off credit card debt.
How do I handle the deduction on my tax return?
Record keeping will make claiming the tax deduction easier. Keep invoices from contractors, and look for your Form 1098 from your mortgage loan servicer or lender at the end of each year. To claim the mortgage interest deduction and lower your taxable income, you'll have to itemize deductions using Form 1040, Schedule A. Claiming the standard deduction won't allow for writing off mortgage interest as an individual cost.
A tax professional can offer guidance customized to your unique situation.
A mortgage preapproval shows borrowing possibilities
Cash-out refinancing combines a new mortgage refinance and a home equity loan into one loan with one monthly payment.
A pre-approval can help you see whether this type of mortgage would improve your finances.
Better's pre-approval requires only a soft credit check so it won't affect your credit score.
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