Do you have equity in your home that you want to tap into for one reason or another? Whether you want the money to fix up your home or to go on a dream vacation, you can do what you want with it – it’s your money.
The main concern many borrowers have, though, is if they’ll have to pay taxes on it, since they think it’s income.
Luckily, you don’t have to pay taxes on cash-out refinance proceeds. We help you understand the reasons below.
A Lack of Capital Gains
Even though you increase the cash you have in your possession when you do a cash-out refinance, you don’t increase your net worth. That’s what the IRS looks at when deciding if they should tax your earnings.
Here’s an example to make it easier to understand:
You own a home that is worth $350,000. You also have a mortgage on it that has a balance of $100,000. While it looks like you have a net worth of $350,000, you haveto deduct the debt you have on the home, so your net worth is $250,000.
Now let’s say you tap into your home’s equity to get some cash. You take out a loan of $250,000. That puts $150,000 in your hands. You’d think your net worth would increase accordingly, but it doesn’t. Know you have a home that’s worth $350,000 plus cash in hand, which totals $150,000 for a total net worth of $500,000. There should be taxes there, right? But, you also now have debts of $250,000, which makes your net worth $250,000, the same as it was before you refinance.
So you don’t have to pay taxes on your earnings from a cash-out refinance.
Deducting the Interest on Your Loan
One area that you may want to be careful when it comes to refinancing and taxes is the interestthat you pay on the loan. This is when the reason for the refinance will play a role in what you owe. Typically, you can write off the interest on a loan when you buy a home. You may even write off the interest on a second mortgage if it was used to buy the home.
When you take out the cash-out refinance, though, things are a little different. You aren’t taking money to buy a home. Now the IRS wants to know what you did with the money. Did you take it out to reinvest it back in the home? Maybe you added on a room or redid the home’s flooring. If that’s the case, you can typically write off the interest on the cash-out refinance. But, if you use the funds to consolidate debt, take a vacation, or any other reason that doesn’t pertain to your home, you may not be able to write the interest off that you pay.
Think Before Selling the Home
Now, a time when the taxes might catch up to you with the cash-out refinance is when you sell the home. The IRS will tax your capital gains. They first allow you an allowance of $250,000 if you are single or $500,000 for joint filers. Any money you make beyond the respective amount becomes taxable when you sell the home.
The IRS compares the original purchase price of the home to the price you sell it for today. The difference is the capital gains. But you only pay taxes on the amount above and beyond either $250,000 or $500,000. In reality, you’ll pay these taxes either way, so if you need the money now to enjoy, go for it. Just know that you may owe taxes on the money down the road.