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 to use 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 related to the process. To simplify your refinance, 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 to you as a lump sum of cash. Because the cash comes from home equity you already built and comes 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 money on taxes with a cash out refinance so long as funds go toward qualifying expenses. Use this cash out refinance calculator to help you 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 realize 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 like a home improvement.

Can you make a cash out refinance tax deductible?

The interest you pay on a cash out refinance may become tax deductible via the Home Mortgage Interest Deduction if the cash is used for capital improvement or goes toward mortgage discount points. A capital improvement is a permanent addition, upgrade, or enhancement to your home that increases its value. While a capital improvement generally means home improvement, not all home improvements or renovations qualify. For example, things like painting a room or fixing a leaky pipe aren’t capital improvements.

Capital improvements may include projects such as adding a pool to your backyard, paving your driveway, or building an addition to your home.

Making sure your cash out refinance tax is deductible might be complicated, so you should enlist the help of a trusted, knowledgeable tax professional before proceeding. They should help you determine what home improvements can count as capital improvements.

Cash out refinance tax deduction limits

You should take note that 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 capital improvements. Interest from cash used on other purchases, such as a vacation, can’t be deducted from your taxes.

For example, let’s imagine you pull $50,000 from your equity with a cash out refinance, with $40,000 going toward a new pool and $10,000 toward a vacation. In this scenario, you may be able to deduct the interest paid on the capital improvement value — which is the interest on $40,000.

Also, homeowners may typically only claim a deduction on interest for up to $750,000 in total mortgage debt. So, if someone 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 cash.

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 fit 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). In general, tax deductions for these loans work similarly to cash out refinance deductions.

Home equity loan

A home equity loan is a type of second mortgage on your home that allows you to tap into your home’s equity. Instead of replacing your current mortgage, a home equity loan allows you to retain your existing mortgage and access additional money. This means that you keep your current mortgage rate and still pull equity from your home.

Like cash out refinances, home equity loan interest is tax deductible only when the cash is used for capital improvements. Also, you can only deduct interest on your total mortgage debt (your mortgage plus the home equity loan) up to $750,000, and your total mortgage debt cannot exceed the home’s value.

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 similar conditions as home equity loan interest. For interest on a HELOC to potentially qualify for a deduction, the cash must go toward a capital improvement in your home, and interest may only be deductible on up to $750,000 in your total mortgage debt. Also, you can typically only deduct interest on cash from a HELOC, not your total approved line of credit.

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 employ to create tax deductions using the money from your cash out refinance. Using a cash out refinance may give you a way to 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.