Cash out refinance tax implications

Colorful single-story home with a garden in the front yard

A cash out refinance offers a way to tap into your home equity without getting a second mortgage. It lets you refinance your existing mortgage and update its terms while borrowing additional cash from your equity for things such as home improvements, debt consolidation, or emergency expenses. However, taking out cash during a refinance may make many homeowners wonder about potential tax charges or deductions. To simplify, we’ve broken down what you need to know about the tax implications of a cash out refinance.

Is a cash out refinance taxable?

If you’re wondering whether a cash out refinance will impact your taxes, the good news is that it may lower your total taxable income.

A cash out refinance lets you pull equity from your home in the form of cash.
Instead of paying taxes on a cash out refinance, you may be able to save money through tax deductions, up to specific limits.
If a cash out refinance doesn’t work for you, alternative options that may also come with tax deductions are available.

A cash out refinance works much like a traditional rate and term refinance. However, with a cash out refinance, you’ll have a larger outstanding balance on your new mortgage than your previous mortgage, with the difference paid out as a lump sum. Because the cash comes from home equity you already built and is provided to you as a loan, any money from a cash out refinance is not taxable.

While a cash out refinance may cost money upfront depending on closing costs and fees, you might save on taxes with a cash out refinance so long as funds go toward qualifying expenses. Use this cash out refinance calculator to estimate the monthly payment of a cash out refinance.

Looking for a low fixed rate on a cash out refinance? Discover® Home Loans offers refinancing options between $35,000 - $300,000 with $0 application fees, $0 origination fees, $0 appraisal fees, and $0 costs due at closing.

Is cash out from a refinance considered capital gains?

Capital gains taxes are typically only paid when you sell an asset and make a profit. With a cash out refinance, you borrow money against the equity in your home. Since you’re not selling your home, the proceeds from a cash out refinance are not considered capital gains.

Do I pay taxes on my cash out refinance?

You do not have to pay taxes on your cash out refinance. In fact, the interest you pay on a cash out refinance could be tax deductible if the funds go toward a qualifying expense.

Can you make a cash out refinance tax deductible?

The home mortgage interest deduction may let you deduct all or some of the interest you pay on a cash out refinance from your taxable income. To be eligible for this deduction, you must use the borrowed funds to “buy, build, or substantially improve” the property that secured the loan, according to the IRS.

A substantial improvement is one that adds to the value of your home, prolongs your home's useful life, or adapts your home to new uses.

Simply repainting your home or making other repairs that maintain your home’s condition aren't considered substantial improvements by the IRS. However, the IRS might consider something like painting your home to be a substantial improvement if it's part of a more extensive renovation.

Knowing whether the interest on your cash out refinance tax is deductible or partially deductible might be complicated, so it may help to work with a trusted, knowledgeable tax professional. They should also help you determine what home improvements count as substantial improvements.

Cash out refinance tax deduction limits

There are limitations to the deductions your cash out refinance can provide.

For starters, you may only be able to deduct the interest on the cash used for substantial improvements. Interest from cash used on other purchases, such as a vacation, can’t be deducted from your taxes.

Imagine you pull $50,000 from your equity with a cash out refinance, with $40,000 going toward a substantial improvement and $10,000 toward a vacation. In this scenario, you may be able to deduct the interest paid on the substantial improvement value—which is the interest on $40,000.

Also, you may only claim a deduction on interest for up to a certain amount of total mortgage debt. According to the IRS, you can deduct home mortgage interest on the:

The first $750,000 of indebtedness (the amount you owe) when filing single or married filing jointly or
The first $375,000 of indebtedness when married filing separately

So, if someone married and filing jointly took out a cash out refinance for $800,000, then $50,000 of the loan’s interest would not be tax deductible regardless of how they used the money.

Higher limitations apply if you want to deduct mortgage interest from indebtedness incurred before December 16, 2017: $1 million when filing single/married filing jointly or $500,000 when married filing separately.

Cash out refinance alternatives

While cash out refinances are excellent tools, they’re not the best fit for everyone. If a cash out refinance does not match what you are looking for, you may also be able to pull equity from your home with a home equity loan or home equity line of credit (HELOC).

Like with a cash out refinance, you may be able to deduct all or some of the interest you pay on these loans from your taxable income.

Home equity loan

A home equity loan is a type of second mortgage on your home that lets you tap into your home’s equity. Instead of replacing your current mortgage, you keep your current mortgage at the same rate and pull equity from your home with the home equity loan.

Like cash out refinances, home equity loan interest is tax deductible only when you use funds to buy, borrow, or substantially improve the property securing the loan. Also, you can only deduct interest on your total mortgage debt (your first mortgage plus the home equity loan) up to $750,000 and must meet other requirements.

Home equity line of credit (HELOC)

A home equity line of credit, also known as a HELOC, is another great way to borrow money using the equity in your home as collateral. However, HELOCs work differently than cash out refinances or home equity loans. Instead of receiving a lump sum of money once the loan closes, a HELOC will give you access to a line of credit backed by your home’s equity. HELOCs also often come with variable interest rates that can change throughout the loan term.

HELOC interest may be tax deductible under conditions similar to home equity loan interest. For interest on a HELOC to potentially qualify for a deduction, the cash must go toward buying, building, or substantially improving the home secured by the loan, and interest may only be deductible on up to $750,000 in your total mortgage debt.

Closing thoughts: Cash out refinance tax implications

Cash out refinances are an excellent way to tap into the equity in your home without potentially triggering a taxable event. On top of that, there may be some strategies you can use to create tax deductions with your funds. Using a cash out refinance may improve your home and reduce your tax burden at the same time.

Make sure to contact a tax professional to receive advice on what the tax implications may be in your unique situation.

If you think a cash out refinance is the best option for you, check out our refinance application checklist to see what you need to do to prepare for your application.

Please note: Discover Home Loans does not offer HELOCs.

The information provided herein is for informational purposes only and is not intended to be construed as professional advice. Nothing contained in this article shall give rise to, or be construed to give rise to, any obligation or liability whatsoever on the part of Discover Bank or its affiliates.