Conducting a cash-out mortgage refinancing is a way to lower your tax bill. And we all want to lower our taxes!
You should defer or shield as much income as comfortably possible until retirement to minimize your present tax bill. The odds of your retirement income equaling your working income is slim-to-none. Therefore, your retirement tax rate will be much lower.
Cash-Out Mortgage Refinancing
In the process of refinancing my primary residence mortgage down to around 2.5% for a 5/1 ARM, it dawned on me to also check what the rates are for my conforming rental mortgage.
I just refinanced my rental property last year from a 30-year fixed at 5% down to a 5/1 ARM at 4% because I took a stance that rates weren't going anywhere, and that I would pay off the loan in 5-6 years time. Mortgage interest rates are back down to all-time lows as of 2021.
It turns out that I can refinance my rental property mortgage down to 3.375% from 4% with no out of pocket costs. At 3.375%, all the costs are baked into the rate.
Conventional wisdom says to refinance your mortgage whenever you see rates 50bps (0.5%) lower than your existing loan, with a break even period of 12 months or less. With a break even period of 0 months, and 75bps lower, refinancing now is a no-brainer!
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My net income from this particular rental is around $1,000 a month. That's after HOA dues, mortgage interest, maintenance, depreciation and property taxes. Not huge, but better than a poke in the eye.
If I had no mortgage at all, the net income would be closer to $2,400 a month at today's rent, which is an income stream I've been planning for since first purchase. Unfortunately, I pay about a 30-33% effective tax rate (federal + state) on the rental income thanks to the progressive nature of our income tax system.
Then a light bulb went on………….
How To Lower Your Taxes By Doing A Cash-out Refinance
Banks always want to make money, and one of the ways is by lending good creditors lots of money! The mortgage officer said that I could do a cash-out refinance up to 75% LTV of appraisal value.
In other words, if the property appraises for $700,000, and I only have a $300,000 mortgage (43% LTV), I could cash out $225,000 ($700,000 X (0.75-0.43)) and increase my mortgage size to $525,000 ($700,000 X 0.75).
Wouldn't you like to have an extra liquid $225,000 lying around for only 3.325% a year to charter a private jet and make it rain in Vegas? Tempting! But realistically, let's understand how doing a cash-out refinance shields you from taxes.
A $300,000 mortgage at 4% costs about $1,433/month, and after all other costs, the net rental in this example yields $1,000/month. Meanwhile, a $525,000 mortgage at 3.375% costs $2,321 a month. The net rental income of $1,000 practically gets wiped out, which is a good thing, because now you won't have to pay 33% taxes on it while working! That's a nice $3,960 LESS taxes to pay a year thanks to a cash-out refi for now.
Reinvest Your Cash-Out Refinance Money
The other benefit of having $225,000 cash in the bank is that you can choose to invest, gamble, blow yourself up, or do whatever you want.
Ideally, you would simply find a tax free and “stable” municipal bond fund that pays over 3.375% and hold it to maturity. Or, you can invest in a diversified real estate fund like the ones from Fundrise to get high-single digit percentage returns.
Finally, let's say the property market absolutely detonates. At least you'll have pulled out a good chunk of change and have something to show for it.
Only when you're retired, and no longer earning an income that commands a 33% effective tax rate will you pay off the entire mortgage. During retirement, I expect my effective income tax rate to fall to 15%, thereby saving 18% (33%-15%) X $12,000 = $2,160 a year.
Retirement Income Will Likely Be Less Than You Work Income
People fool themselves into thinking that if they can make say $100,000 a year on average from their job, they can generate $100,000 a year in passive income by saving and investing for decades.
Newsflash!
At today's risk free rate of <1% on the 10-year government bond, you will need $10 million bucks to generate $100,000!
And if you are in the top tax bracket and make say $1 million a year, you will need $50 million bucks to generate that level of income and pay the same taxes!
This is the argument why paying taxes now and doing a ROTH IRA is dumb. It's better than not saving, but tax planning wise, it's foolish.
Stop deluding yourself into thinking you'll be making the same amount of money in retirement.
Your goal – especially for those of you in the highest income tax brackets – should be to pay as little taxes now, and defer as much income as you can comfortably allow during your retirement years to minimize your tax burden.
The government isn't putting your money to good use, and half the US population isn't contributing any federal income taxes. As a result, you might as well not contribute as much either!
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With the new tax law, it is better to carry mortgage on rental property rather than principle home. The concept of acquisition debt is really meaningless. Any law should be based on FMV of the rental property when it was acquired. It seems to me that law states that interest on cash out in excess of original acquisition debt will not be deductible. Is there a way to challenge this in tax court. Does any one know the process?
I am also in same dilemma. Is IRS able to enforce this. Is there a way for them to find out your principle on loan increased?
I just came across this as I was following up on research. Basically, what I found agreed with what several others have said here: if you do a cash-out refinance, interest on the first $100,000 of cash taken out is deductible.
Assuming this is correct, doesn’t it follow that nearly everyone with homes worth $100k or more should just maintain a $100k debt in perpetuity while investing the cash they’ve taken out?
Suppose you are in the 25% bracket and mortgage rates are 4.1%. Since 25% of the interest is deducted from your taxes, the effective cost of the mortgage is 3.075%. Conclusion: if you can find a $100,000 investment that generates more than 3.075% over a reasonable horizon, go for it.
Please check my math.
Pam,
You can take one or more loans for up to $100,000 from a primary or secondary residence provided that you don’t exceed the fair market value of the house.
See IRS Publication 936 (Home Mortgage Interest Deduction) for more information.
If the loan exceeds $100K, it can’t be deducted as home mortgage interest as it treated as personal interest. However it may qualify as a student loan interest.
According to IRS Publication 970, if you make less than $75k single / $155 married filing jointly, then you can deduct the interest EVEN if you claim the standard deduction (i.e. itemize).
A common approach is to put money into a Section 529 plan to pay for qualified college expenses especially if it is a long time before your child goes to college. If they don’t go, you can roll the funds over to a relative of the beneficiary.
Sam-
Don’t you have to pay taxes on the cash-out refi on the rental property if you do not invest it in rental property?
PEJ –
You do not have to pay taxes on cash-out refinances. That is because the asset (cash) that you get is balanced by an equal liability (the loan increase). Therefore there is no change in net worth and no profit or loss to be taxed.
my rental condo is valued at $400,000. I owe $225000. If I refinance and take cash out can I keep it in a bank accout incase i need it for my children’s education? What is the best way to do this.
I have a $100,00 loan on my primary residence.Valued at $650,000
Thanks for your reply.
Wow this just makes me feel like I have a long way to go and so much to learn! I’ve had my house for a few years now and just starting to pay down the principle. I have never invested into stocks, always thought it was risky.
I’m still pretty young and always thought of having real estate as a form of retirement ‘security’. Wouldn’t buy a house to rent unless if the rents covered all of the expenses. This is something my wife and I are currently working towards. Seems like an up hill battle, as time goes by, our money is worth less and less.. so when retirement comes, we will need much more of it to survive.
PS. I’ve heard of unicorns existing but only from those who’ve smoked the magic dragon..
Great post. Bottom line, there’s more than one way to skin a cat. Interesting takes on cash out refis and not investing in Roths. When I started my Roth I was being optimistic. I’ll be rolling in the dough at retirement. Second, who knows where the tax rate will be down the road. But I do see where you are coming from. Thanks!
Can you (or Sam) explain why Sam does not think it make senses to invest in a Roth – thanks.
I went to Sam’s post about Roth’s but that was about converting from a regular IRA to a Roth were you would have to come up with $ to pay for the conversion.
However, I qualify for a Roth and fully fund my 401K and thus it seems like it makes sense to put $5,000 into a Roth. I have to pay tax on this money this year anyways and all gains I get will be tax free.
What am I missing?
Thanks!
I guess I am a pessimist, but I think tax rates will go high enough that my taxes in retirement are just as high as they were in my working years, even though I have less income.
I converted to Roths as I hope to get my children and grandchildren to hang on to them to take advantage of a long, long period of tax free accumulation. That, of course is assuming Uncle Sam leaves the concept alone (which is probably doubtful).
I don’t like owing real estate where the cash flow doesn’t cover the expenses – the cash out refi you talk about is – as Krantcents notes- a calculated risk, and one I am not currently willing to take.
Wow, that is very, very pessimistic or OPTIMISTIC b/c you believe we are heading towards massive Socialism or that you will make tons of money!
Definitely don’t buy real estate if the rent doesn’t cover your costs!
We do not need anymore “socialism” than we currently have for tax rates to dramatically increase. Why – Medicare, Medicaid and to a much lesser degree Social Security.
Sam,
How about having your net cash flow on the rental exactly match your depreciation on the property… that way you are cash flowing but have no taxable incoming coming in from the rental?
-Mike
That’s exactly the goal! The $1,000 is after deprectiation too, so I’m trying to figure out whether this cash out refi to raise interest expense is the right plan, right now with rates this way.
OK Sam, for the strict terms of the code: the interest on the original mortgage is acquisition debt (the debt actually used to acquire the home) so all of that interest is deductible. This is where the easy part ends.
If you use any of the $225,000 to improve on the home that amount allocated specifically to improvements would be 100% deductible and considered additional acquisition debt.
You have a $400,000 difference between the original loan balance and the FMV which exceeds the $100,000 cap for deducting home equity debt, so if you use the cash for anything other than improvements, you can only deduct the interest up to that $100,000 debt limit.
If you are going to look at things from a more loose interpretation, if the original cost of the home is the same as or greater than the new loan amount, you can consider the new loan an acquisition debt and deduct the entire amount.
It’s kind of difficult to give an example due to all of the variables and what-if’s that go into something like this. It is a pretty tricky area where taxes are concerned, as there isn’t a specific flowchart to follow for this particular type of transaction. Plus, everyone is going to interpret it differently
The issue isn’t what the cash-out funds are for, but rather what is securing the loan. A loan secured by a home is considered deductible, whereas cash-out of a car refi or other item of collateral is not qualified.
IRS Publication 936 clearly points out that Home Equity Debt is indeed qualified and deductible. The general rule is that it is the smaller of $100,00 or the difference between the FMV of the the home and the original acquisition debt. Basically, if the difference between the remaining balance on the original mortgage and the FMV is less than $100,000 that is the qualified value that you can deduct interest on.
If you exceed the mortgage interest limitations, you have other options too. You can still claim deductions for the monies and interest paid for education expenses, business interest expenses, investment interest expenses but it does get a little complicated, and a real sit-down meeting with your tax preparer will be necessary to determine how your situation will play out.
Do you mind using the numbers in this example for better clarification?
FMV = $700,000
Original loan – $300,000
New refi loan – $525,000
Cashed out – $225,000
Thx
totally makes sense as long as mortgage rates are low. so much you can do with the quarter million cash out
What would you do with $225,000 if it hit your bank account right now? I think I’ve got to write a post about this!
@ Travis:
Travis, I just talked to a couple CPAs and a couple mortgage brokers, they said it’s fine as mortgage interest is mortgage interest expense.
For example, let’s say you have a $500,000 mortgage and decide to pay off $200,000 of it tomorrow. Two months from now, rates go down by 1% and you want to do a cash-out refi. You take out $200,000 so your mortgage is back to $500,000, there’s nothing wrong with deducting interest off of $500,000.
The second example is if they have a $500,000 mortgage with a 50% LTV. If the property appreciates by 100%, they have $500,000 more equity and if someone wanted to buy the place and put 50% down, they would put $1,000,000 down and carry a $1,000,000 mortggae. Who is to say you can’t cash out $500,000 and write off $1 million worth of mortgage interest expense, while a new buyer can.
I’ve never considered something like this sam, but then again, the tax man is no where near as cruel in wyoming as he is in California. It sounds like a good way to invest more, like RB40 said!
This is absolutely incorrect. If you use the loan proceeds for anything other than acquiring the rental property or upgrade the property, you CANNOT deduct the interest expense against your rental income. See IRS publication 535. The expense must be traced back to the use of the proceeds to determine the type of interest expense it can be categorized. In your example, if you take out the additional $225,000 proceeds and invest in tax-exempt muni bonds, that portion of your interest expense will be disallowed.
Really? Please tell me more! What you say actually makes sense, however, how does the IRS determine this? A refi is a refi. What if we are in an ever inflating interest rate environment? Or, I took out a ne am floating mortgage at 1.5% and now I have to refi to 6.5%. My interest expense increases by 4X and all of it is tax deductible.
Thanks for your thoughts!
There’s nothing wrong with refinancing for the same principal amount — you haven’t pulled any equity out of the property, so the proceeds can still be traced to the acquisition of the property, be it investment or qualified residential. The issue comes with you take more than the balance at the time. Of course there’s no way for the IRS to really “catch” this since most 1098 forms do not contain principal information or finance conditions. However, in the event of an audit, they will certainly disallow it.
What were all these stories about people going crazy with their HELOC’s buying TVs and vacations and stuff? Surely they were writing off the interest no?
Tell me more about your background pls. Are you an accountant? Bc I love accountants!
HELOC is only suppose to be used for home improvement
too or else you can’t deduct interest. Personally, I don’t think the IRS will know
what you use it for unless you get an audit…
retirebyforty is right, the chances of the IRS catching this is probably the same chance that you’ll get audited.
And yes, I’m a CPA. I specialize in tax and financial planning for high net worth individuals.
Question from twitter: Dbl check on that. Say you had a 500k mortgage, you pay down 400k in year 1. Then you cash out refi to 300k. Deductible?
Why wouldn’t this be deductible?
Travis, I just talked to a couple CPAs and a couple mortgage brokers, they said it’s fine as mortgage interest is mortgage interest expense.
For example, let’s say you have a $500,000 mortgage and decide to pay off $200,000 of it tomorrow. Two months from now, rates go down by 1% and you want to do a cash-out refi. You take out $200,000 so your mortgage is back to $500,000, there’s nothing wrong with deducting interest off of $500,000.
The second example is if they have a $500,000 mortgage with a 50% LTV. If the property appreciates by 100%, they have $500,000 more equity and if someone wanted to buy the place and put 50% down, they would put $1,000,000 down and carry a $1,000,000 mortggae. Who is to say you can’t cash out $500,000 and write off $1 million worth of mortgage interest expense, while a new buyer can.
But in each of those cases, the mortgage interest can be traced back to acquiring the property, or you are not pulling out more cash than you originally withdrew.
Example one, your original acquisition debt is $500,000. You never took out more than this, you simply put money in and took it immediately back out. No problem here.
Example two, I disagree with, and so do several of my co-workers. The reason they would be able to write off $1 mill while you can’t is that $1 mill is their acquisition debt. Yours was only $500K. Anything over $500K that you take out and do not use for home improvement is not deductible in my opinion.
Again, the code is grey here, and I’m probably more conservative than some of my counterparts.
Sam and Travis,
Thanks for you comments regarding this matter. I know this will help me and I expect others. I quickly paid off my origninal 5.25% mortgage. However, rates keep dropping – thus I think Sam’s idea of increasing the mortgage might make sense.
David M
I would guess that even if Travis is write about it not being allowable, he is probably wrong about the chances.
I would say the chances of the IRS catching this is much lower than the chances of being audited.
Why, the IRS usually does not do full audits – they ask you about a specific matter that hits a red flag – home expense deduction, high charitable deductions, etc. Interest deductions are less likely to hit a red flag – IMHO.
“write” of course should be “right” or “correct”
Sure, you may be correct in that it may never be caught. But as a CPA, I cannot advise clients to report false deductions simply because the likelihood of getting caught is slim to none…
I agree that you should neve advise someone else to report a false deduction.
I’m also a CPA – I took about $2,000 out during my last refinancing and I got $2,000 back when I purchased my home – I’m surely taking the full interest rate deduction.
Thanks for replying to my comment.
I haven’t thought about refinancing to reduce tax. I think it’s a great idea. You can use the liquidity to buy more properties in this depressed market. The pros also refi to take profit from property price increase instead of selling a rental property. Refinancing is a great tool for avoiding tax! You also get to write off more interest when you take out cash right?
Good parallel on the Roth IRA. The government is smart to prey on the hopes of young people to get them to pay more taxes now. Silly young people. They’ll learn.
I don’t get – if you have money to invest – why is a Roth IRA a bad idea?
Thanks for your reply,
David M
The reason is in the first paragraph of the article and towards the end. And here’s a detailed reason why https://www.financialsamurai.com/2010/01/11/be-a-sloth-and-dont-roth/
That seems to be a reason to not convert a regular IRA to a Roth IRA. However, if I have money that I have already paid taxes – and meet the IRA income levels for that year – it seems to make sense to me to put the money into a ROTH. I already paid taxes on this income once and now I will never have to pay taxes on any gains again. Seems better than investing that $5,000 in the stock market and having to pay taxes on the gains.
This is a very interesting idea. I can’t put this into practice now, because a) my income tax bracket is not that high, and b) my single rental property which I purchased one year ago is financed at about 80% already. But I’ll definitely keep in mind refinancing as a possible strategy to lower tax liability and pull cash out in the future.
It is a risk, but a calculated risk. As I near retirement, I have become risk averse and wish to shed debt vs. take more on. If I had more time, I would take out cash and invest it.
My retirement income will approximately replace our current income. Since I will no longer out asiide retirement savings or have dedcutions, my net income rise. Combine that with lower expenses since my mortgage will be paid off, it will rise somewhat. I plan on drawing less than 3% from my IRA.
Hey Sam, I like your idea of using the cash out re-finance to reduce taxes, especially to ensure you don’t have too much of your assets in real estate. I’d want to be fairly conservative about choosing which municipal bonds to invest your money in as many states and towns are cash-strapped and could possibly default in the future.
I think you’re greatly over-generalizing the issue on the Roth IRA. It’s a very different circumstance for a lot of people. For someone in the middle of their career, it rarely makes sense to contribute to a Roth IRA since you’re likely at the top of your earning tax bracket, and you hope your taxes will go down in retirement (assuming tax rates don’t rise very quickly).
For younger individuals, Roth IRA contributions can make a lot of sense. With a max MAGI of around $106k (for singles) to contribute to a Roth IRA, the highest marginal tax rate you can be in is the 28% group and most people are probably in the 15-25% area. With the likelihood of taxes going up in the future ($14+ trillion deficit and growing) and already being in a low tax group, there’s a very good chance that your working tax rate will be lower than your retirement rate for younger workers.
As a young professional, I’m trying to stash my money in Roth accounts for now. I’m planning to retire enough assets that could cover $100k+ of income a year (in today’s dollars). If all goes well in my career, I’ll be unable to contribute to a Roth IRA within 2 years due to income eligibility, so I’ll then switch over to adding more to a traditional 401k. I think it’s important to have both traditional and Roth (if it makes sense for you to currently invest in a Roth) accounts since it can help you to keep your tax rates lower in retirement. For example, you could take out taxable money from your 401k up until you hit a new tax bracket, and then use tax free Roth money to ensure you don’t pay any taxes in the next marginal tax bracket.
Brilliant! We did a cash-out refi on our mortage to get a better rate. We had 8 years left on the mtg. & no bank wanted to refi it. So we did a cash-out to cover the cost of buying our van (which we needed). It was a lower rate than we could get on a car loan so it was a good deal for us. It put our mtg. up to 10 years with our payment only slightly higher than we’d had. We thought it was a good deal all around. Your idea of using money to invest is sonething that is very intriguing. I’ll be turning it over in my mind for a while! Thanks!
When you did the cash out were there any tax forms? Does the government require taxes of some sort on that cash when it hits your bank account?
There are no forms – it is not income. It is a loan.
No forms. As David M says, it’s a loan so no problem.
so you’ve taken a 5yr car loan and made it a 30yr car loan…brilliant!!!
This is the argument why paying taxes now and doing a ROTH IRA is dumb. It’s better than not saving, but tax planning wise, it’s foolish.
Why is a Roth IRA dumb – if I have already maxed out my 401K and have extra cash – why is it dumb to put that extra cash into a Roth IRA?
“Do you believe you will be able to generate as much retirement income from your investments as you do from your day job income?” Not exactly – however – if I’m willing to annuitize my 401K then I think I might be able to – especially if interest rates climb a bit. Yes I realize: 1) this is not what you asked and 2) I’m taking a risk that if I die the next day this was a VERY BAD DECISION.
I refinanced last year to a 4% 10 year loan – I’m currently refinancing to a 10% – cost baked into the refinance loan at 3.5%. Rates are now lower than when I locked 3 weeks ago – maybe next time I will cash out as my morgage is about 49% of the value of my property.
the 10% in the last paragraph should be 10 years. That means I’m extending my payments by 1 year but since the rate is so low I think this makes sense – I’d rather have extra cash available for other purposes.
Converting to a Roth is dumb, but if you’ve maxed out your 401k, go ahead and contribute to a ROTH and not before.
$5,000 a year iRA contribution is going to do jack do do for anybody’s retirement.
Thanks – I just wanted to make sure I was not missing something.
It will not have a large impact on my retirement BUT I figure it is better to shelter the money from taxes than not shelter it from taxes.
Again, thanks for the reply!
David M