If you invest in real estate, like me, then you may have built up some decent equity in some of your investment properties. And that means that you can cash out on that equity with a refinance.
But how does that affect your taxes?
The IRS treats the loan from a cash out refinance different from a normal mortgage or business loan. You are not taxed on the equity you pull out of the home, and depending on how you use that money, you can in fact deduct the interest you pay on the loan from your taxable income.
If you have the option, a cash out refinance is just as great as a traditional loan, and they are much easier to qualify for.
Cash Out Equity To Invest
It’s a common theme in my writing to point out the advantages of borrowing money to invest. In real estate investing, the power of property appreciation is amplified several times over when you leverage your money and take out a loan to invest.
The same is true for almost every other type of investing. At it’s simplest, we can see that investing in something like the stock market, that gets 8-12% ROI, will be profitable if you buy the stocks with a 4-6% interest loan.
When the investment outperforms the interest on the loan, you win.
And getting that 4-6% loan can be difficult depending on your financial situation. So we, as investors, must often get creative to find that money.
When you can’t get a traditional mortgage, you may borrow from your 401k or call up hard money lenders.
Or you can cash out on the equity you have in real estate you own, even the house you live in.
Cash out refinance is an excellent loan for investing
The last time Kate and I bought real estate to list on Airbnb, one of our normal lenders told us that our debt to income ratio was getting to a point where they were having a hard time getting us approved.
Even though all our investments were cash flowing positively, each new investment negatively affected our debt to income ratio.
Looking ahead to our next investment we’ve tossed around several ideas. One of them is to use the cash out refinance on the property we own.
Edit: It looks like we’re going to use a commercial lender for our next investment, but cash out refinance is still on the table.
Why is a cash out refinance so attractive?
- It’s SUPER easy to get approval
- The terms are great
Often, you can automatically get approval for a cash out refinance because your home acts as collateral for the loan. Even if it’s not automatic, the criteria are much looser than they would be for a traditional mortgage or business loan.
The terms are what you would get on a home mortgage, so you can do up to a 30-year term and usually get interest rates below 5%.
Are You Taxed on the Amount You Cash Out?
And oh yeah, the money you get from a cash out refinance is tax-free. So that’s pretty nice too.
You don’t even have to use the money to invest. You can use that money in any way you want and you don’t have to claim it on your taxes (Although how you choose to use the money can affect how much of your loan interest you can deduct from your taxable income).
If you withdraw money from a 401k, it shows up as taxable income (although lending to yourself from your 401k is tax-free).
Basically, the IRS taxes free money, but doesn’t tax a loan. Since the money you get from a cash out refinance is actually a loan (and you’ll be paying interest on it), it isn’t considered taxable income.
We see this same tax treatment when looking at 1031 exchanges. When you complete an exchange and end up with boot (usually extra cash), then you pay taxes. But if you end up with a bigger loan, then the exchange is tax free.
Deduct the Interest Paid
Not only is your cash out refinance money tax free, but you can typically claim a tax deduction on the interest paid on the loan.
Note: You may not be able to deduct 100% of your loan interest after a cash out refinance depending on how you use the money you take out. You can reference the mortgage deduction tax code for more information. Always speak to a tax professional before making important financial decisions.
In fact, there are several items associated with your mortgage that you can use to reduce your taxable income:
- Interest paid on the loan
- Points paid on your mortgage
- Late payment charges
- Prepayment penalties
- Interest paid on a home equity loan
- Mortgage insurance premiums
Your lender should send you a Form 1098 in the mail after the 1st of January. This form reports how much you paid in interest and points during the year.
It helps to keep your own records, but my accountant never asks for my investment property mortgage statements. He just uses the 1098.
From a tax perspective, a cash out refinance on your investment properties can usually be nothing but good. You don’t claim any of the money from the refinance and you should get to deduct some or all of the interest paid on the loan.
This is part of why I’ve seriously considered a cash out refinance on one of our long term rentals to help purchase another property.
I’m my mind, a cash out refinance is equal to a traditional mortgage or business loan when using that money to reinvest. The tax benefits are great.