Before considering whether a cash-out refinance a wise financial decision, there are numerous things to consider. A cash-out refinances your current mortgage but adds more money to the new loan that the borrower receives in cash.
People often arrange a cash-out refinance to acquire a lump sum of money to use however they want, in addition to a better mortgage loan. However, the money from a cash-out refinance is not taxed as income.
Is taxable income created with a cash-out refinance?
Withdrawing money from an IRA or selling bonds are two examples of cases where receiving an inflow of cash counts as taxable income. However, rolling over cash is not one of those occasions.
The reason is that, even though you gain a large sum of cash, the income from a cash rollover is a loan, not income.
Instead of withdrawing funds from an account that generated income, you borrow money against home equity and must repay that sum over time.
Therefore, you are exempt from including the withdrawal amount as income on your tax return.
How does a cash-out refinance work?
A cash-out refinance is used by both investors and homeowners to convert the equity in a home into cash. A cash-out refinance is a current loan with a new mortgage greater than the amount still owed on the home rather than selling the home outright.
To observe this better, we can take some examples. Suppose the current fair value of the house is $250,000 and its mortgage balance is $150,000. Now, the equity in the home is $100,000, and the total of the new loan is $200,000.
For example, in a cash-out refinance, the investor or homeowner must withdraw a maximum of $50,000 in cash from the asset.
The amount is determined by deducting the new mortgage of $20,000 from the balance of the old mortgage of $150,000.
Is there any tax to pay on this refinancing?
The IRS does not classify the money obtained from a cash-out refinance as income or capital gain because, technically, the home is not sold during the process.
Since the mortgage balance and loan payments increase when cashing out a home through a refinance, obtaining it in cash is comparable to getting a loan.
To better observe this, we can consider the following example: how the monthly mortgage principal and interest payments vary when obtaining a cash-out refinance.
|
Before collecting the refinancing |
After collecting the refinancing |
|
|
Mortgage amount |
$150,000 |
$200,000 |
|
Principal payment |
$216 |
$287 |
|
Payment of interest |
$500 |
$667 |
| Mortgage payment in full | $716 |
$954 |
Cash-out refinancing is not a taxable event. The financial return on investment and the pre-tax income a property produces is affected by refinancing a rental property to cash out.
Requirements to qualify for a cash-out refinance
Since not everyone is eligible for a cash-out to refinance, paying attention to the loan qualification requirements is critical. In other words, you may not qualify for this option if you don’t have enough equity in your property. What most borrowers require to be eligible is the following:
- To have at least 20% equity in their home.
- To have the prerequisites for a conventional mortgage, such as a low debt-to-income ratio, a high credit score, and a reliable source of income
Visit a marketplace like Credible to find out if you have the right loan-to-value ratio to qualify for a cash-out refinance. Enter your loan amount to see if refinancing would be financially advantageous. Another option is a mortgage refinancing calculator.
For example, to qualify for a cash-out refinance on a home priced at $400,000, you will typically need a current loan debt of 80% of the value, or $320,000 or less. Although some lenders will extend credit up to 90%, 80% as a norm.