You can tap into the equity you've built in your home with a cash-out refinance. With a cash-out refinance, you borrow more than you owe on your current mortgage and receive the excess in cash. However, though you're still using your home as collateral, that doesn't mean that you can automatically continue to claim all the interest you pay as part of the mortgage interest deduction.
No Taxable Income
Performing a cash-out refinance is just like taking out an additional loan in terms of generating income. When you receive cash out in a refinance, the IRS recognizes that you have to pay it back, and so you really haven't realized any income. Therefore, it doesn't count as taxable income. For example, if you refinance your mortgage for $200,000 when you owed $170,000, you would receive $30,000 cash. However, your loan increases to $200,000, so you still have the same net worth.
Requirements to Count as Mortgage Debt
If you don't use the proceeds of your cash-out refinance to improve your home, you can't treat the interest on the cash-out portion of the the refinance as home mortgage interest. For example, if your refinance is for $200,000 but $30,000 of it was cashing out, usually you could only treat the interest on the first $170,000 as mortgage debt. However, if you used the $30,000 to add on a room to the back of your home, the entire amount counts as mortgage debt.
Home Equity Debt Deduction
If you don't use the proceeds of the loan for improving your home, all is not lost. In addition to the mortgage interest deduction, the IRS also allows you to deduct interest on your home equity debt, which is debt secured by your home but not used to buy, build or improve your home. However, the deduction limits are significantly lower and the home equity debt plus any other debt secured by the home cannot exceed the fair market value. As of the 2011 tax year, you can only deduct the interest on the first $100,000 of home equity debt -- $50,000 if you're married filing separately. For example, if you received $30,000 as part of your cash out, you could deduct all of the interest. However, if you cashed out $300,000, you couldn't deduct all of the interest.
Discount Points on Mortgages
When you refinance, your lender may offer you the option of paying points to receive a lower interest rate on the refinance. If you use the proceeds of the cash out to pay for home improvements, you can either deduct the points in the year you pay them or prorate them over the remainder of the mortgage. If you don't use the proceeds to improve your home, you have to prorate the points. For example, if you take out a 15-year refinance and pay $3,000 in points, you would deduct $200 per year.
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