Planning

Tax Implications Of Investment Property Cash Out Refinance

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 a cash out refinance just like a normal mortgage or business loan. You are not taxed on the equity you pull out of the home, and you can in fact deduct the amount you pay in taxes on the loan from your cash out refinance.

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% 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.

Related: How to do Airbnb market research for free

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?

  1. It’s SUPER easy to get approval
  2. 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.

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 claim a tax deduction on the interest paid on the loan.

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.

Conclusion

From a tax perspective, a cash out refinance on your investment properties can be nothing but good. You don’t claim any of the money from the refinance and you actually get to deduct 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 a website.

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.

Happy investing.

Michael

I'm living the path to financial success and sharing everything I learn in this blog. I believe in the power of cash flowing investments, due diligence and time. This is my journey so far.

Before 2016: Just living my life, working full time and trying to get by.

2016: Kate and I start to discuss the possibility of getting into real estate investment. We read books like Rich Dad Poor Dad and listen to the Bigger Pockets Podcast. We find a Realtor and start looking at property. We even make an offer or two, but nothing happens.

2017: Kate and I continue looking for property. We meet with banks and find lenders willing to work with us. In one month (August), we turn our basement into an Airbnb and list it AND we purchase our first long term rental property, which is a triplex. We can't find good tenants for our triplex.

2018: In April, we finally get our first tenant in the triplex, our second in June and get it fully rented in July. Our basement Airbnb makes so much money that in September we decided to buy another property to exclusively rent out on Airbnb. It makes us even more money than the first one!

2019: Kate decides we should put together a mastermind group. So we get in touch with people we know who care about money and start sharing knowledge with each other. Our triplex is profitable, but our two Airbnb properties are making way more money, so we buy another property to put up on Airbnb and VRBO.

2020: Coronavirus hits in March and all the guests booked at our Airbnb properties cancel. We freak out, but after a few weeks everything comes back and we're making money again. Discussion and research from the mastermind group makes me want to investigate online business as an investment strategy. Kate and I started Unbound Investor with plans to purchase a website in 2021.

OK you're all caught up!

I learned everything I know from books, podcasts, conversations with friends and family and of course through real world experience as a cash flow investor. And I'm always pushing to learn more.

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