Business Management

Stop! Before You Refinance, Consider These Tax Traps & Opportunities

Expertise: Business Management, Real Estate Investing Basics, Personal Finance, Personal Development, Real Estate News & Commentary, Mortgages & Creative Financing
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Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal or financial advice related to individual situations. Consult with your own CPA, attorney, and/or other advisor regarding your specific situation.

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Over the last few years, real estate prices have appreciated significantly. Many investors have taken out loans and also done refinances. It may come as a surprise to you that before taking out loans, you should think of it as a potential planning opportunity and meet with your tax advisor.

With appreciated properties, we are often faced with a decision of whether or not to sell a property. If you were going to sell the property, you would likely incur selling expenses. These might include putting in some repairs to get it ready for the sale, commissions to be paid upon the sale, and worst of all, taxes to be paid to Uncle Sam if you do not have a solid plan in place to defer the taxes.

Alternatively, if you chose not to sell the property, you can instead do a cash-out refinance. With a cash-out refinance, you have no real estate commissions, no rehab is needed, and most importantly, no taxes are due.

As a result, many savvy investors have tapped into the equity of their properties using cash-out refinances. From a tax perspective, we love cash-out refinances. The reason is simply that loan proceeds are not taxable. We have also seen many investor clients who refinance simply to get better rates and terms.

One should keep in mind, though, that just because refinance proceeds are tax-free, how the refinance is structured can have a significant impact on your overall taxes.

When done correctly, it can result in a significant amount of tax savings. When done incorrectly, it can result in a lot of lost tax deductions.

Let’s take a look at some common refinance scenarios and dive a little deeper into the good, the bad, and how to do them correctly.

Refinances on Primary Homes

Under tax reform, there are now new limitations with respect to mortgage interest deductions on primary homes. If you took out a new loan on your primary residence after December 14, 2017, then the deduction for mortgage interest is limited to the interest on a loan balance up to $750,000.

If you haven’t refinanced your first mortgage on your primary residence or haven’t purchased a new home since December 14, 2017, then your existing loan is grandfathered in at the previous loan limit of $1,000,000.

calculator with less tax and more tax buttons

This new $750,000 loan limitation can be avoided if your loan proceeds are used for investment purposes. For example, we have seen a lot of clients whose homes have appreciated in value. As a result, many have decided to do a cash-out refinance on their primary homes and to use those cash-out proceeds to buy or improve on rental real estate. In those scenarios, the interest deduction is not limited to only $750,000 worth of debt as long as it can be shown that the additional, cash-out loan proceeds were used for investment real estate.

It is extremely important to make sure that there is a way for you to show the money is being used for investment purposes. Although some of the interest might be limited as an itemized deduction on your personal return (depending on your loan balance), the portion of the interest attributable to the cash-out proceeds (that were used to buy or improve your rentals) can be tax deductible against your rental income.

The same benefit can be applied for a home equity line of credit. Even though under tax reform, interest paid on a home equity line of credit on your primary home is no longer tax deductible, it certainly could still be deductible against rental income if the HELOC proceeds were used on investment real estate.

Also, it’s worth throwing out there that if you refinanced on your primary home and used the loan proceeds instead to go on a personal vacation or for some other personal things, the interest on that could become non-deductible.

So, the key here is to make sure that you are able to show loan proceeds being used for investment purposes when refinancing from your primary home. One of the easiest ways to do that is to open a separate bank account and deposit your refinance proceeds into that account. Then, use that new account for real estate purchases or improvement activities for your rental properties.

Related: The Ultimate Guide to Real Estate Taxes & Deductions

Refinances on Rentals

The same applies to refinances for your rental properties. Let’s assume that one of your rentals in Arizona has appreciated in value over the last few years. You want to continue holding on to the property but don’t want to leave all of that equity in there. Instead, you plan to do a cash-out refinance on that property and end up using that money to buy another investment property in Minnesota.

In that scenario, the interest is still deductible as a rental expense. Although the loan is secured by the Arizona property, you would deduct the interest against the Minnesota property, because that is the property that the loan proceeds were used for.

One thing to keep in mind is that at the end of the day, it does not really matter that the loan on the Arizona property was deducted against the Minnesota rental. The reason is, for most investors, all of the rental income and expenses of the various properties may be netted together at the end of the day anyways. So, the end result is that the interest expense on the new loan should be fully tax deductible.

Just like primary home loans, you will want to have a clear way of showing that the loan proceeds from the rental refi were used for other rental properties. This helps to ensure that the interest remains tax deductible in the event of an IRS audit.

Just like above, if you refinanced your rentals and used that money for personal things or vacations, the interest on that portion may no longer be tax deductible.

man standing in front of desk drinking coffee and going over paperwork

Where Things Get Complicated

As mentioned previously, it is very common for investors to refinance their rentals to buy more rentals, and it’s also very common for investors to refinance their primary homes to buy more rentals.

Now, what about someone who refinances their rental property and uses that money to buy a primary home? Or used that money to pay down their mortgage on their primary residence?

Unfortunately, the answer to these questions is not as taxpayer friendly. In either of these two scenarios, the interest on the portion of money used for the primary residence would not be tax deductible. It wouldn’t be deductible against your rental income, because that portion of the money wasn’t used to buy or improve your rental properties. And the interest wouldn’t be deductible as primary residence mortgage interest (as part of itemized deductions) either because of a little-known tax-trap.

Related: How to Maximize Your Write-Offs of Travel Expenses

In order for interest to be deductible on Schedule A as primary residence mortgage interest, the loan that generated that interest would need to be secured by your primary residence. So in our examples above, the loans would be secured by the rental property, so the interest on the portion used for a primary residence would unfortunately not be tax deductible—even though the proceeds were used for such.

Accordingly, the best thing to do is to use your cash or other available funds for the down payment of your primary home and use the refinance proceeds from your rental properties for rental-related expenses.

As you can see, not all loans are treated the same. Using refinances correctly can help you maximize your tax savings, while using it incorrectly can mean lots and lots of lost deductions each year. This is why it is important to consult with your own tax advisor and plan accordingly before you take out any loans!

Look for more tax advice from Amanda Han, CPA, in her latest title The Book on Advanced Tax Strategies: Cracking the Code for Savvy Real Estate Investors, available for pre-order February 5.

Questions on tax strategies surrounding refinances?

Ask me below in the comment section.

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 ye...
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    Wade G. from Houston, Texas
    Replied 12 months ago
    Interesting because I have been thinking about refinancing a couple of rentals and using the money to pay off my primary mortgage. Then opening a HELOC on my primary in case an investment opportunity comes along. Maybe that is not such a good idea.
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Hi Wade: Yes we typically dont recommend refi on rentals to pay off primary. You can certainly take out a HELOC on primary and use it for rentals....that allows the HELOC interest to remain deductible as a rental expense.
    Leo Grinberg from MN
    Replied about 1 month ago
    So I'm wondering if it is still make sense to payoff primary mortgage when I don't do itemized deduction anyway. I refinanced my rental with cash out because I couldn't get anybody willing to refinance principal under $150k($135k to exact) or the interest would be too high. By taking $100k out i moved from 5% to 3% on rental. My principal on primary is under $100k at 3.25% and same thing. Nobody wants to refi it. I now understand that I can't deduct full interest on new $235k loan but if I payoff primary I would lower my real estate payment by $700 per month. I did some remodeling in the same rental replacing kitchens. Rental is a duplex. Does it still make sense in my case? At least in my opinion I'm not losing anything. Thanks in advance.
    Jerry W. Investor from Thermopolis, Wyoming
    Replied 12 months ago
    Amanda, Excellent article as usual.
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Thanks for reading Jerry!
    Christopher Stacy Rental Property Investor from Wiesbaden Germany
    Replied 12 months ago
    Wow this is an amazing article. Can't wait to read your book! Thanks!
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Thanks Christopher!! Cant wait for the book to come out and hope you will enjoy it!
    Kerry Baird Rental Property Investor from Melbourne, FL
    Replied 12 months ago
    I’m grateful for this article, as I have recently refinanced a rental and was looking for a personal use of funds. Instead, I put in an offer on a fixer. Thanks for enabling me to correct my course!
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Great decision Kerry and thanks for sharing your story!!
    Kevin Chan
    Replied 12 months ago
    Can the cash-out be used toward a syndication? and still deduct the tax?
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Hi Kevin: Yes the interest can still be tax deductible against rental income (assuming this is a rental syndication).
    Cindy He
    Replied 12 months ago
    Is there a time limit if the money from refi just sitting in the bank account?
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    No time limit but just keep in mind that when it is sitting in the bank, the interest is not deductible in the interim.
    Kevi Lynn from Redmond, Washington
    Replied 12 months ago
    I would like the answer to this as well.
    Jovan Hardwick Flipper from Saint Petersburg, FL
    Replied 12 months ago
    Great article! It's seems like you post these type of articles when we most need them. I will be moving closer to doing this in a few months and look to set-up a consultation before proceeding with my refi. Again, thanks for everything you do for the site.
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Thanks Jovan and glad you found the article helpful!!
    Steve Porter Investor from Akron, Ohio
    Replied 12 months ago
    Very eye opening!! Great article! I’m curious as to if you took a loan out on your rentals to repay the cash you paid for the rentals initially, how that would be taxed?
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Generally the interest is still tax deductible provided this is done within 30 days of acquisition.
    Kevin Buzek
    Replied 12 months ago
    Perfect timing for me as well. I met with loan officer this week who said that it will cost me 1% to refinance and cash out equity on my primary residence since I plan to use that money to buy an investment property. He showed me the Fannie Mae tables referencing LLPA (loan level price adjustment) matrix. Does this sound correct?
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Glad you found the article helpful Kevin. I recommend you have a clear way of showing the refi proceeds being used for the new investment property.
    David Thompson
    Replied 12 months ago
    “ Also, it's worth throwing out there that if you refinanced on your primary home and used the loan proceeds instead to go on a personal vacation or for some other personal things, the interest on that could become non-deductible.” This doesn’t make any sense to me. Why would a refinance make any difference than purchasing a new home in regards to interest deductibility?
    Hein A. Rental Property Investor from Queens, NY
    Replied 11 months ago
    Very informative and useful article. Thanks Amanda!
    Amanda Han Accountant from Fullerton, CA
    Replied 11 months ago
    Thanks for reading Hein!
    Joe Evans Rental Property Investor from Orlando, FL
    Replied 11 months ago
    Amanda, Great article! That information is very helpful in preparing last years taxes. Every $$counts.
    Jerry Akia from Los Angeles, California
    Replied 9 months ago
    Thank you, Amanda for the great info. I have 2nd and 3rd HELOC. Can I refinance just the 1st and keep the 2nd and 3rd as it is?
    Katherine Davis
    Replied 8 months ago
    This article is very helpful, as I am in the process of doing a cash-out refinance on my rental property. I plan to put all of the cash that comes from the refi in a separate account. If I use that account for expenses related to my rental, including paying my mortgage, taxes, repairs, etc., does that portion of the interest become deductible on Schedule E, as those expenses occur?
    Ayan E Das
    Replied 7 months ago
    Very helpful article Amanda. I have a question. I have zero mortgage balance on my worth primary residence, and doing a cash-out refinance on my primary residence, and use the entire money to purchase a rental property. Assuming I keep track of tracing the funds from the cash-out re-fi for purchasing the rental property, I understand that I can deduct the interest on the cash-out re-fi against the rental income in form Schedule E. My question is, in Schedule E, do I show the interest of the cash-out re-fi in line 12 of Schedule E (Mortgage interest paid to banks) or in line 13 (other interest)? Can I deduct the mortgage interest of the cash-out refinance loan on the Schedule E form, and use the mortgage interest against the rental income? I will keep the money from cash-out refi in a separate checking account, and use the money from the checking account to buy the rental property, so that I can clearly show that the money was indeed used to buy the rental. I have heard opinions that says both yes and no to the above questions, and Google search could not provide a definitive answer
    Matt Corbett
    Replied 6 months ago
    I just wanted to confirm your understanding on refinancing of a rental property and tax consequences. I found the following link that says the property being refinanced must be a primary or secondary residence. I would take that to mean you can't deduct mortgage interest payments for loan used to refinance a rental property. Is that correct? Quote: "With any mortgage—original or refinanced—the biggest tax deduction is usually the interest you pay on the loan. Generally, mortgage interest is tax deductible, meaning you can subtract it from your income, if the following applies: 1) The loan is for your primary residence or a second home that you do not rent out 2) The loan is secured by your home. This means your home serves as collateral for the loan; if you fail to make your payments, the lender can foreclose on the home 3) You "itemize" deductions on your tax return, meaning you list all of your deductible expenses, add them up, and then deduct the total amount from your income. The alternative to itemizing is to take a standard tax deduction, which is a set amount you can claim regardless of your actual expenses. (Learn more about itemizing with "What Are Itemized Tax Deductions?")"
    Amanda Han Accountant from Fullerton, CA
    Replied 6 months ago
    Hi Matt: Thanks for your question. If you refinance on a rental property and use the refi proceeds to invest in rentals, the interest is deductible as interest expense against rental income. Hope this helps.
    Gaurav Parekh
    Replied 6 months ago
    Hi Amanda, thank you for writing such a great article. Similar to the 750K limit on primary is there a similar limit on rental property. If I do a cash out on a rental property and invest in another rental property are there any capital gains tax implications in california? Thanks.
    Rocco Swinney
    Replied 6 months ago
    hi amanda! thanks for the great article. The one piece i am unclear on is... i understand if for example i used 50k cashout refi on my rental to buy another rental then i can deduct the interest from the full 50k. However, say from my rentals i have about 50k yearly in property taxes, repairs, insurance, etc. if the 50k was used to cover the expenses on my other current rentals is that still deductible?
    Amanda Han Accountant from Fullerton, CA
    Replied 6 months ago
    Hi Rocco: Yes that would be deductible as rental expense.
    Rocco Swinney
    Replied 6 months ago
    thanks so much :-)
    Terry Day
    Replied 5 months ago
    Great article. I am still a little unsure. I have a rental in AZ. I was able to buy in 2011 when the bottom fell out of the real estate market there. I now owe around $55K, and I would think it would now appraise around $250K. I live here in NM. My question to you is, If I would do a cash out refi and take out $50K, can I use the money to pay off my principal mtg here in NM ( $26K, Balance ) car loan ( $13K, Balance ) and lot next door I purchased 8 yrs ago ( $8K balance ). I would be debt free with the exception of the rental. If I can use the money for this, would it be considered taxable income, capital gains,etc. ?
    Amanda Han Accountant from Fullerton, CA
    Replied 5 months ago
    Thank you for your email. Know the loan proceeds would still not be taxable and not subject to capital gains when you take the proceeds out. You do want to make sure you have a clear way of showing the money being spent for each of those activities you listed as some of those are tax-deductible and some of those are not when it comes to the interest expense.
    Ethan Hyder
    Replied 5 months ago
    Hi Amanda, thanks for this article. What are the tax implications if the funds from a rental cash out are used to buy an RV? Given the current environment, and if that RV is beginning used as a home office in the driveway or even possibly a rental source after things have returned to some form of normalcy? And would it matter that the RV was purchased with cash 2 weeks prior to the cash out loan application being initiated? Thanks!
    Sean Li
    Replied 5 months ago
    Thanks for the article, Amanda. Really helpful. Can I clarify with you on a slightly nuanced scenario? If I do a cash out refinance of my main home, and use the cash-out proceed to pay off the existing mortgage on my rental property (not to buy a new property), then I should deduct this part of my main home's mortgage interest against my rental property in Schedule E going forward according to the tracing rule. Is that correct?
    Patricia Mclaughlin
    Replied 4 months ago
    Great article Amanda. Let's assume that the cash-out proceeds were used to pay off the rental loan, and was traced to the rental and deducted against the rental income. What happens when the rental is sold? Does this portion of the interest become non-deductible once the rental is gone? Or would it revert to investment interest?
    Amanda Han Accountant from Fullerton, CA
    Replied 4 months ago
    Hi Patricia: It would just depend on what you use the money for once the rental is sold. So if it is used for more rental properties, then it would continue to be rental interest expense.
    David Van Woerkom
    Replied 4 months ago
    Hi Amanda, thank you for that article. I have a question about limits on home mortgage Interest deductions for cash out refinancings where the cash is used for capital improvements. I have tried to find the answer in IRS publication 936 (2019) and am confused by the language in the publication (page 9 and 10). Two paragraphs seem to contradict one another. My question is what are the restrictions on when the money must be spent on capital improvements. Does it have to be within a certain number of days before or after the refinance loan closes? The language in the publication seems to indicate you that you can only apply capital improvement expenses that occurred prior to the loan closing date (with a 24 month lookback period). This implies that capital improvement expenses incurred after the loan close date aren't applicable. That doesn't seem realistic in scenarios where someone doesn't have the funds to complete the capital improvement project upfront and would like to complete the project after the funds have been borrowed. Can you help me understand what the regulation requires/allows on this topic?
    John Schroeder
    Replied 4 months ago
    Great article. I'm considering adding a loan to my Arizona rental property and use the proceeds to pay off a loan on a Washington rental property. Primary reason is to refinance to a lower rate, but having the loan on the AZ property instead of the WA property will reduce AZ income tax. Can I deduct the mortgage interest on that type of refinance against the AZ rental property? I'm a CA resident, and a non-resident taxpayer in Arizona.
    Amol K.
    Replied 3 months ago
    You mention that the cash out from a cash-out refinance on that an Arizona property can be used towards the down payment of another investment property in Minnesota. Can you not use the proceeds to re-imburse yourself for the down payment you made long time ago, on the Arizona property itself, assuming that the cash-out is not more than that down payment?
    Thu Nguyen
    Replied 3 months ago
    This is an excellent and clear article with well explained examples! I was thinking of doing a cash-out refinance on our rental to purchase a primary residence. But I will not now based on your explanation above that the interest on the portion of money I had planned to use for the primary residence would not be tax deductible. And the interest wouldn’t be deductible as primary residence mortgage interest (as part of itemized deductions) either because of a little-known tax-trap. Thanks for your article!
    Larry Lee
    Replied 3 months ago
    Great article Amanda. Let's assume that the cash-out proceeds from my primary home were used to pay off two rental loans for two rental properties. Is it ok for the two rental properties and deducted against one form 1098 each year? and how? Thanks for your great article!
    Todd Sprague
    Replied 3 months ago
    Amanda, I have appreciated rentals in Oregon (where I live) and Arizona. Income tax rate in Oregon is 9 percent, Arizona 2.59 percent (based on the limited income I have there). I was thinking of doing a cash out refinance of one to pay off the other, reduce interest rate and possibly reduce term (for long term interest savings as I head toward retirement). If I would allocate interest deductions to each property I used the money for, in which state might I want to refinance (e.g., which property) for best tax savings? Thanks.
    Jordan Mol
    Replied about 2 months ago
    hi Amanda - great article thank you. We're considering consolidating two mortgages with a cash out refi on our primary home. The two mortgages are a vacation home (no rental income) and our existing primary home mortgage. We have plenty of equity, great cash flow and an attractive rate improvement opportunity. If we do this will all of the new loan interest be fully deductible? The IRS language is a little unclear but this seems to fit the spirit of the rules since the cash out proceeds are paying off a mortgage that was used to acquire the vacation home. thank you
    Paul Wardell
    Replied 26 days ago
    Thanks for the article, Amanda. Please help me to understand the tax implications of my recent refinanced business loan. I refinanced to lower my interest rate from 3.625 to 2.125% Although the bank tried to give me cash out, I have reapplied the entire sum of its overpayment to my new loan. My new loan picks up where the last one ended--but at a lower interest rate. In previous years, the interest I paid on this business loan has been a business expense. Now that I've refinanced, I read that my interest from my previous loan is no longer deductible. I'm not sure what that means. Does it mean that all the interest I have paid on that loan from this year and previous years needs to be added to my basis? If so, does it mean I have to pay back all those years of deductions? Does it mean the only interest I've paid this year needs to added to my basis? As you can see, I'm confused. Thank you for your help. Paul
    Katy L. from Bay Area, CA
    Replied 16 days ago
    Great Article Amanda! I've got similar questions and hoping you can provide a quick answer - I would like to refi cashout on one rental property and use the cashout portion to pay off the another rental property mortgage. Can I deduct the mortgage interest as business expense if I show where funds are allocated? The IRS publications for Mortgage Interest and Business Expenses are not clear. Hope you can help shed some light :)
    Karen Kasjaniuk from Tallahassee, Florida
    Replied about 19 hours ago
    So grateful to have found this article! I really appreciate you taking the time to break down the details. Any idea if there are changes in store to these rules in 2021?