Many homeowners today are sitting on a veritable piggy bank compared to past homeowners. If you have a mortgage on your home, you usually have the option of refinancing in order to get additional cash at any time. There are several ways you can do this, but the best option if you need a lump sum of money upfront is often a cash-out refinancing.
Cash-out refinancing is a type of mortgage refinancing that benefits both you and the bank. For instance, if you owe $60,000 on your house still and would like to take out additional cash, you can get your mortgage refinanced for $80,000, then get the difference of $20,000 in cash. In exchange for the extra money and interest you will have to pay the bank, you may receive a better interest rate.
This is not the same thing as a home equity loan, since it replaces your first mortgage instead of functioning as a second loan. You will also have to pay closing costs, which can amount to somewhere between hundreds and thousands of dollars.
The distinction is important, as “cash-out refinancing” is dealt with for tax purposes by the IRS in a distinct way, and the details can be found in publication 936 by the IRS, entitled “Home Mortgage Interest Deduction” and available online. In addition to the original debt incurred to purchase the home, you're allowed to take out up to $100,000, and deduct the interest. The loan must be secured and you must be legally liable for it in order to receive this tax benefit. Other restrictions apply, including the purpose of the funds you withdraw and what your home is used for. If you are eligible for this interest deduction, you can claim it on Schedule A of form 1040.
Perhaps more important to know upfront is that the lump sum of cash you receive upfront (in the example above, $20,000) will not be taxed according to federal regulations. It is counted as borrowed money, since it must eventually be repaid – either over the new term of the mortgage or when the property is sold.
It may, however, be eventually taxed when the home is sold, depending on the capital gain or loss the home sale results in. Since every situation differs, consulting a professional tax advisor is always the best way to ensure you comply with regulations and receive the maximum tax benefit from a home sale or loan refinance.
