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