Do You Have to Pay Taxes on Home Equity Cash-Out?

Home equity cash-outs are a financial strategy for homeowners seeking liquidity without selling their property. This involves refinancing a mortgage to access the built-up equity in a home, providing funds for purposes such as renovations or debt consolidation. A key question arises: do these cash-out proceeds come with tax obligations?

Distinguishing Loan Proceeds From Taxable Income

Homeowners who pursue a home equity cash-out refinance access their property’s equity by refinancing their mortgage, resulting in a lump sum of money. Under U.S. tax laws, these proceeds are not considered taxable income. The IRS treats them as a loan to be repaid, not as income that increases wealth.

The distinction lies in the concept of economic benefit. Taxable income typically refers to realized increases in wealth, like wages or dividends, whereas loan proceeds are offset by the obligation to repay the borrowed amount. For instance, if a homeowner receives $50,000 in cash-out proceeds, this amount is not taxable because it is classified as a liability, not income.

Deductions Linked to Cash-Out

Though cash-out refinance proceeds are not taxed, homeowners may qualify for certain tax benefits depending on how the funds are used.

Mortgage Interest

The mortgage interest deduction allows taxpayers to deduct interest on mortgage debt if the loan meets specific criteria. The debt must be secured by a qualified residence, and the proceeds must be used to buy, build, or substantially improve the home. For loans taken out after December 15, 2017, the Tax Cuts and Jobs Act limits the deductible mortgage debt to $750,000. For example, if cash-out funds are used to renovate a kitchen, the interest on that portion of the loan may qualify for the deduction.

Qualified Home Improvements

Using cash-out refinance proceeds for qualified home improvements can yield tax benefits. Qualified improvements are those that add value, extend the property’s useful life, or adapt it to new uses, such as installing energy-efficient windows or adding a new roof. These costs can increase the home’s basis, potentially lowering capital gains tax liability when the property is sold. Homeowners should maintain detailed records of improvement expenses to substantiate claims with the IRS.

Capital Expenditures

When cash-out proceeds are used for capital expenditures—such as upgrading or maintaining physical assets—these costs can be added to the property’s basis. This can reduce taxable gain upon sale. For example, funds used to build an additional room can be capitalized. Properly categorizing these expenses ensures accurate tax reporting.

Implications of Selling the Property

Selling a property after a cash-out refinance introduces financial and tax considerations. The outstanding mortgage balance, including the cash-out amount, must be paid off at the time of sale, affecting net proceeds.

Capital gains tax implications depend on the timing of the sale. The IRS allows an exclusion of up to $250,000 for single filers and $500,000 for married couples on capital gains from the sale of a primary residence, provided the homeowner lived in the property for at least two of the last five years. Selling shortly after a cash-out refinance may limit eligibility for this exclusion, particularly if the property is not a primary residence.

The use of cash-out funds can impact the adjusted basis of the property, which is crucial for calculating capital gains. Funds spent on substantial home improvements can increase the property’s basis, reducing taxable gains. Proper documentation of these improvements is essential for substantiating any adjustments. Additionally, selling a property after a cash-out refinance may affect credit scores and future borrowing capacity.

Record-Keeping for Tax Purposes

Effective record-keeping is critical for homeowners who engage in home equity cash-out refinances. Copies of loan agreements, closing statements, and lender correspondence are essential for documenting financial transactions.

Receipts and invoices for expenditures funded by cash-out proceeds are particularly important when claiming adjustments to the property’s basis. Maintaining a detailed timeline of improvements, including costs and descriptions of each project, can help homeowners support their claims in the event of an IRS audit. Organized documentation simplifies tax reporting and ensures compliance with IRS guidelines.