How to Use Cash Refinance and Deduct Your Taxes
When you take out a cash refinance, the rules surrounding the tax deductions associated with the mortgage are a little different than for a traditional mortgage. The IRS sets specific guidelines for tax deductions related to capital improvements, renovations, and mortgage points.
Below is an overview of the possible deductions you could take on your taxes. Before committing to any of the following options, consult a tax professional. With their specialized expertise, they can help you create an effective tax plan based on your overall tax situation.
Make capital improvements
Many owners choose to use a cash-out-refinance for home renovations. If the improvements are considered capital improvements by the IRS, you can claim the mortgage interest deduction. To be considered capital improvements, they must improve the property, not just maintain or repair it.
Here are some of the improvements that may be considered capital improvements:
- Add a swimming pool to your property
- Added a privacy fence
- Add another room to your home
- Updating your roof
- Replacement of central heating or cooling systems
- Upgrade to Energy Efficient Windows
Here are some of the home improvements that are not considered capital improvements:
- Repair a broken central heating or air conditioning system
- Painting interior parts
- Repair broken walls or windows
Home renovations can improve your bottom line because it means you can deduct mortgage interest from your taxable income. Beyond that, capital improvements increase the total amount you’ve spent on the property, which can reduce your capital gains tax liability when you sell the home.
Either way, it’s essential to keep a detailed record of your receipts for future reference.
Add a home office
Home offices have grown in popularity over the years. If you’re doing a cash refinance to add a home office, there are a few tax savings opportunities on the table.
First, this choice of use of funds means that you can deduct the cost of interest paid on your refinanced mortgage from your income taxes.
Additionally, small business owners or self-employed individuals can claim a portion of your mortgage as a business expense. You can either claim a simplified deduction of $5 per square foot if your home office is less than 300 square feet, or take the regular deduction based on the size of your office relative to the rest of your home.
However, claiming a home office deduction is only allowed if your business is entitled to regular and exclusive use of the space. For example, an office serving as a guest bedroom will not qualify. Additionally, the home office should be a primary location of your business that you use on a regular basis.
Renovate a rental property
If you are pursuing a cash refinance on a rental property, funds used for renovations may be considered tax deductible. Indeed, the renovation of a rental property is a business expense for the owners.
This is one of the many tax benefits of real estate investing.
Buy mortgage rebate points
When closing a cash-out refinance, the lender may allow you to purchase mortgage points. Rebate points offer a discount on mortgage interest rates in exchange for an upfront fee.
Depending on the amount of your loan, mortgage rebate points can be a significant expense. The cost is tax deductible, which may reduce your tax liability. But you are not allowed to deduct the full amount in the same year you refinance. Instead, the cost of discount points should be spread over the term of your loan.
For example, let’s say you buy $3,000 in rebate points from your lender on a 30-year refinance. Each year, you will be allowed to deduct $100 from your taxes until you repay the loan.
