Cash out Refinance Tax Implications

9 Replies

There are several posts on this topic but I am still struggling with a clear understanding. 

From what I have read on BP, it seems like there is no taxes that will need to be paid when one does a cash out refinance. If this is the case then why don't investors (especially flippers) use this as a tax strategy to avoid any gains tax on the property. What I mean by that is; before someone sells a property they refi to the max allowed LTV (say 80%) and then sell the property after the refinance. If done correctly the refi closing costs would be less than the gains taxes they would need to pay for the sale.

Ex.

Purchase price $150,000, renovation costs $20,000, ARV $250,000

After renovation the investor would refi to 80% LTV (or the maximum possible amount). In this case they could pull out $50,000 minus say $3000 in closing costs.

After the refi the house would be sold for a gain of only $30,000 instead of $80,000.

Could this be used as a valid tax strategy?

So the original loan amount is $150000, a new loan (through refinancing) is taken out for $200,000 (80% of $250,000 the new appraised value). So the investor gets $50,000 tax free from the refinance. When the property is sold for $250000 the investor will have to pay off the new loan of $200,000. The difference will be $50,000 but the investor can clam $20000 in renovation costs against that $50000 gain. So in the end the investor will pay gains tax on $30000. 

I hope this clears it up a little but this is a rather complicated scenario. 

I was referring to a cash out refi not a HELOC. The money to cover the $200k would be coming from the new buyer. There would be a 50k surplus from the selling transaction after the 200k loan is paid off and I would still have my 50k from the refi.

Originally posted by @Michael S. :

So the original loan amount is $150000, a new loan (through refinancing) is taken out for $200,000 (80% of $250,000 the new appraised value). So the investor gets $50,000 tax free from the refinance. When the property is sold for $250000 the investor will have to pay off the new loan of $200,000. The difference will be $50,000 but the investor can clam $20000 in renovation costs against that $50000 gain. So in the end the investor will pay gains tax on $30000. 

I hope this clears it up a little but this is a rather complicated scenario. 

Unfortunately that's not how it works.  Mortgage principal payments are not tax deductible.  So, although the money from the initial cash-out refi isn't taxable (because it's a loan and not income), you also don't get to claim some sort of tax exemption when you pay it back or exclude it from the overall capital gains. 

Originally posted by @Michael S. :

I was referring to a cash out refi not a HELOC. The money to cover the $200k would be coming from the new buyer. There would be a 50k surplus from the selling transaction after the 200k loan is paid off and I would still have my 50k from the refi.

Cash out vs. HELOC isn't the issue - the principle is still the same. In your scenario your capital gain on the property is 100k. You can't remove the 50k capital gain that you pulled out early and not pay taxes on it.

@Michael S.

Your taxable profit is the difference between what you PAID for the property and the net proceeds from the sale of the property.  The presence or absence of financing does not change the taxable profit.

Buy the property for $150K, put another $20K into renovations and you have PAID $170K for the property.  Sell for $250K and you have an $80K taxable profit.  Makes no difference whether any part of your purchase price is financed, nor how often it was refinanced -- the capital gain calculation is done without regard to the amount of any financing involved.

@Michael S. What was said above is correct. I'll try to phrase it a little different and maybe it will make it clearer:

The IRS looks at your numbers at the end of the year. Here is what will be recorded on your tax return

Jan 2015 - buy house:  (-150K)

March 2015 - finish rehab  (-30K)

May 2015 - refinance - (don't care)

December  2015 - Sold house +250K

__________________________________

Totals:

Expenses: 150K + 30K + {whatever interest and fees paid for both mortgages}

Income: 250K

Taxable: Income - deductible expenses

__________________________________

Hope this helps the fact that you had a mortgage or took the money from a friend means nothing to the IRS more than the amount you can claim as a deduction for the interest paid.

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