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Do you have to pay any taxes after a cash out refinance?

Form 1040 With Tax Check and Money
by Jeff Rohde, posted in Investment Strategy

Real estate investors are always looking for ways to put money to work. 

With the way home prices have been rising over the last few years, an investor may have a surprising amount of equity in a home. Doing a cash out refinance is one way to turn accrued equity into cash to reinvest. 

But one of the questions that frequently comes up is whether money from a cash out refinance is taxed. 

In this article, we’ll explain how a cash out refinance works, whether or not a cash out refinance is a taxable event, and some ways an investor can put funds from a cash out refi to work.


Key takeaways

  • A cash out refinance is a strategy used to turn accrued equity in property into cash without selling.
  • Since a cash out refinance is more like a loan, the IRS does not consider money from a cash out refi to be income or a capital gain.
  • Doing a cash out refinance may have an impact on the amount of cash flow and net income generated by the refinanced property.
  • Two ways to put money from a cash out refi to work are by making improvements to add value and increase rental income, and by using the funds for the down payment on another rental property.

 

What is a cash out refinance?

A cash out refinance is a strategy used by investors and homeowners to turn accrued equity in a home into cash. Instead of selling a home outright, a cash out refinance replaces an existing loan with a new mortgage that is greater than what is owed on the house.

Here’s a simple example of how a cash out refinance might work:

  • Current fair market value of home $250,000
  • Current mortgage balance $150,000
  • Equity in the home $100,000 (difference between current value and mortgage balance)
  • New loan amount $200,000 (usually limited to 80% of the market value with a cash out refi)

Based on this example, an investor or homeowner would be able to pull a maximum of $50,000 in cash out of the property by doing a cash out refinance. The amount is calculated by subtracting the previous mortgage balance of $150,000 from the new mortgage amount of $200,000.

 

laptop refinance

Is a cash out refinance taxable?

Since a home isn’t actually being sold with a cash out refinance, the IRS doesn’t consider the cash generated as income or as a capital gain. A cash out refinance is more similar to taking out a loan, because in order to pull cash out of a home with a refi the mortgage balance and loan payments increase.

The following example illustrates how the monthly principal and interest payments on a mortgage might change with a cash out refinance, assuming that the interest rate remains the same:

Before cash out refi
After cash out refi
Mortgage amount $150,000 $200,000
Principal payment $216 $287
Interest payment $500 $667
Total mortgage payment $716 $954

A cash out refinance isn’t a taxable event. However, refinancing a rental property to pull cash out does have an impact on the financial performance of an investment and on the pre-tax income the property generates.

 

Financial effect of a cash out refinance

Let’s look at the effect that a cash out refinance of a rental property might have on two financial performance metrics: Net cash flow and pre tax income. 

Cash flow

Before cash out refi After cash out refi
Income
Rental income $30,000 $30,000
Pet rent $300 $300
Total Rental Income $30,300 $30,300
Expenses
Property management <$2,400> <$2,400>
Repairs & maintenance <$600> <$600>
Insurance <$1,300> <$1,300>
Property taxes <$2,500> <$2,500>
Mortgage payment <$8,592> <$11,448>
Capital reserves <$800> <$800>
Total Expenses <$16,192> <$19,048>
Total Net Cash Flow $14,108 $11,252

In this example, by using a cash out refinance to pull $50,000 in cash from the home, the net cash flow is reduced by $2,856 per year.

Pre tax income

Before cash out refi After cash out refi
Income
Rental income $30,000 $30,000
Pet rent $300 $300
Total Rental Income $30,300 $30,300
Expenses
Property management <$2,400> <$2,400>
Repairs & maintenance <$600> <$600>
Insurance <$1,300> <$1,300>
Property taxes <$2,500> <$2,500>
Mortgage interest <$6,000> <$8,004>
Capital reserves <$800> <$800>
Total Expenses <$13,600> <$15,604>
Total Pre Tax Income $16,700 $14,696

In this example, by using a cash out refinance to pull $50,000 in cash from the home, the net pre tax income is reduced by $2,004 per year.

 

How to use money from a cash out refinance

Money from a cash out refinance can technically be used for anything, such as getting rid of high-interest credit card debt, paying a child’s college tuition, making home improvements, or funding a retirement account.

However, many real estate investors use funds from a cash out refinance to make more money and potentially increase tax deductions. 

Ideally, even though the net cash flow and pre tax income are reduced with a cash out refi, an investor may be able to use funds from a refinance to generate new additional income or tax deductions that minimize the reduction in cash flow or net income from the refi.

Renovations to add value and increase rent

Examples of improvements, upgrades, and renovations made with funds from a cash out refi to add value to a rental property and increase potential rental income include:

  • Updating a kitchen or bathrooms to add value and justify a higher monthly rent.
  • Increase rentable square footage by adding a bedroom or converting a garage, attic, or basement into additional living space.
  • Install energy-efficient upgrades such as new windows and doors, adding insulation, and installing programmable thermostats.
  • Replacing an old heating and cooling system with a brand new system.
  • Put up a new fence to make the property safer to tenants.
  • Re-do the front yard landscaping to improve the curb appeal of a home.

In addition to adding value to the property and justifying a higher monthly rent, another benefit of using money from a cash out refi for capital improvements is the 100% bonus depreciation deduction

Normally capital improvements must be added to the cost basis of a rental property and depreciated over a period of 27.5 year. So, if an owner spent $50,000 in capital improvements, the additional depreciation expense would be $1,818 per year. 

However, between now and the end of the 2022 tax year, an investor may use 100% bonus depreciation to deduct the full cost of capital improvements the year that the expense is incurred. That means instead of depreciation $50,000 in capital improvements of 27.5 years, the entire $50,000 can be deducted 

Depending on an investor’s personal tax situation, any excess net loss generated by the additional depreciation expense may be able to be used to offset other income, or the loss may be carried forward to offset taxable income in future years.

Purchase another rental property

Another way an investor might use funds from a cash out refinance is to fund the purchase of another rental property to generate rental income and tax benefits.

Let’s assume an investor finds a single-family rental for sale on Roofstock for $200,000. 

As a rule of thumb, a lender requires a down payment of 25% to finance a rental property loan. If an investor uses the $50,000 as a down payment to purchase the duplex, the resulting cash flow might look something like this:

  • Rental income: $20,000
  • Property taxes: <$4,500>
  • Property management: <$1,600>
  • Leasing fees: <$500>
  • Insurance: <$1,110>
  • Repairs & maintenance: <$1,000>
  • Capital expense reserves: <$800>
  • Mortgage (principal & interest): <$8,500>
  • Total Net Cash Flow: $1,990
  • Depreciation expense: <$6,545>

In this scenario, an investor is able to use the funds from a cash out refinance to purchase another rental property that generates enough cash flow to significantly offset the decrease in total net cash flow and pre tax income from the original property that was refinanced. 

Of course, in real life, every investment is different, and there’s no guarantee that another investment will generate a specific amount of cash flow or return. That’s why investors take the time to closely analyze different investment opportunities and run the numbers using different pro-forma assumptions.

 

wooden house on cash

Risks of a cash out refinance

While a cash out refinance does not generate a tax liability, there are some potential risks an investor may wish to consider:

1. Different loan terms and conditions

A cash out refinance on a rental property may have different loan terms and conditions from the original loan. For example, a lender may require a borrower to keep additional cash in a reserve account to pay for several months of mortgage payments and operating expenses.

2. Additional closing costs

Closing costs on a cash out refinance generally ranged between 2%-5% of the new mortgage amount. That means if a property is being refinanced for $200,000, the closing costs might run between $4,000 and $10,000. Fees for closing costs are deducted from the funds a borrower receives from a cash out refinance, or a borrower may bring additional cash to the closing.

3. Negative cash flow

Although a cash out refinance requires a borrower to keep 20% of the equity in the home, there is still the possibility that monthly cash flow could be negative. Since a mortgage payment increases with a cash out refi, the cash flow from a property is generally reduced.

 

How to qualify for a cash out refinance

A lender will generally require a maximum loan-to-value (LTV) of 80% for a cash out refinance. That means 20% of any existing equity in the home will need to stay in the home instead of being pulled out as cash.

Other factors a lender might consider to determine if a borrower qualifies for a cash out refi include:

  • Income and assets in bank accounts, retirement accounts, and equity in other properties.
  • Amount of debt a borrower has, including credit card and auto loan payments, student loans, and personal loans.
  • Credit score and credit history.

Loan terms and conditions vary from lender to lender. A good place to begin looking for a loan to refinance or purchase a property is the Stessa Mortgages. After signing up for a free Stessa account, simply log in and go to the Mortgages section under Resources.

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