The tax implications of a cash-out refinance on rental property

Need access to a substantial amount of cash whether to pay for home upgrades, expand your portfolio, or even pay for education and medical bills? You may look at cash-out refinancing as a viable option.

Refinancing is a great tool to raise money by tapping into your home equity. And it is available to the majority of homeowners, not just the rich. Black Knight reports that the average U.S. homeowner had $216,900 in tappable equity in Q2 of 2022. Long-time property investors use this equity to snowball their investments by leveraging the equity they’ve built to buy another income-generating property.

Are there any tax implications for cash-out refinancing on rental property? Is the mortgage interest of a cash-out refinance tax deductible? These are reasonable questions first-time homeowners might ask. In this article, we’ll talk about these things in great detail. But first, let’s look at what cash-out refinancing is and how it works.

Cash-out refinance: How it works

A cash-out refinance is a type of mortgage refinancing that allows you to turn the equity you have in your home into cash. It involves replacing your current mortgage with a new one that has a larger balance. This is so you can take the difference in cash. Because of the nature of how this works, a cash-out refinance is ideal for properties that have gone up in value.

For example, you took a $200,000 loan for a $300,000 home. After many years of mortgage payments, you’ve built an equity of $200,000. Now, assume that the improvements you’ve made over the years coupled with market appreciation raised your property’s value to $400,000. A lender who agrees to refinance 75% of your property’s value will give you $300,000 in cash.

After paying off the remaining $100,000 from your old mortgage, you’ll still have $200,000 you can use for anything.

The most common uses of cash-out refinance include:

• Home improvements
• Buying another property
• Covering medical expenses
• Paying off debt

In general, a cash-out refinance is a useful way to access large amounts of cash by tapping into the equity you have built up in your home. Yet, it also comes with some risks and costs like higher mortgage payments and interest rates, closing costs amounting to 2-5% of the loan amount, or even foreclosure if you can’t keep up with the payments.

Tax implications of cash-out refinance on rental property

Since a cash-out refinance gives you access to large amounts of cash by restructuring your debt, many individuals ask if the money you get from a cash-out refinance is taxable.

Fortunately, the money you get from a cash-out refinance is nontaxable. This is because the IRS views them as an additional liability and not income. Thus, the $200,000 remaining cash from our example above will be received in full.

However, a cash-out refinance isn’t free money. Eventually, you’ll have to pay it back to your lender with the agreed-upon interest. The good thing is, the mortgage interest from a cash-out refinance can be deducted from your taxable income if used the right way.

How to get tax deductions from a cash-out refinance on a rental property

Although you can use the money from a cash-out refinance for any expense, the Tax Cuts and Jobs Act of 2017 placed a limit on what expenses are tax deductible. In general, you can no longer deduct the interest of your loan if the loan proceeds weren’t used to buy, build, or substantially improve your property.

Thus you can’t claim mortgage interest tax deductions if you use the proceeds to pay for personal expenses like high-interest debt, medical bills, or vacations. The best way to maximize tax deductions from a cash-out refinance loan is to reinvest it into your property or grow a rental property portfolio.

Here’s how to use cash-out refinance and get tax deductions.

Invest in capital improvements

Capital improvements are expenditures made to improve or add value to your property. These expenses are typically made to increase your property’s value or prolong its life.

Examples of these expenses include:

• Replacing the roof
• Adding a bedroom
• Renovating a bathroom
• Adding a home security system
• Adding a swimming pool
• Installing a central heating and cooling system

It’s important to note that capital improvement expenses for a rental property are different from repairs and maintenance expenses. Repairs and maintenance expenses are costs that are incurred to keep a property in good working order and are generally considered to be operating expenses.

Buy another rental property

Buying another rental property using the money from a cash-out refinance loan is not only a great way to deduct mortgage interest from your taxable income but also a great way to build your rental property portfolio.

Many investors use Build, Rehabilitate, Rent, Refinance, Repeat (BRRR) method in which the investor leverages the equity built on their properties to buy another rental property.

Other investors use the money from a cash-out refinance transaction as a downpayment to incur more debt and own a larger piece of real estate, thereby, a larger cash flow. If the proceeds from a cash-out refinance are used to buy a rental property, you can claim the mortgage interest as a tax deduction regardless of the method used.