EXPLAINED: Cash-out refinance in BRRRR is not really "tax free"

[Michael Plaks]

"Tax-free refinance" is commonly touted as a great tax benefit of real estate. Is it true? Yes and no.

1. The concept of BRRRR cash-out refi.

It is the 3rd "R" in the notorious BRRRR idea: buy-rehab-rent-refinance-repeat. You buy a distressed property for $100k, put $20k down and get an $80k loan, often a private or hard money loan. Then you spend $30k on rehab out of pocket (or out of your parents' pocket), and the updated property is now worth $150k. 

Since the property is now worth $150k and is in a good condition, lenders will be willing to give you a bigger loan, let's say $120k. From this new $120k loan, you pay off your old $80k loan, and you still have $40k cash left (if we ignore refinance fees and other expenses). This is why it is called "cash-out refi": you walk away with cash in your hands.

From this $40k, you reimburse your old folks $30k for the rehab (to their utmost surprise) and still have $10k of what some consider "profit." Well, you do have $10k for your next investment. A more accurate term would be pulling out your equity, but for taxes the words you use are not important. 

2. And it is tax-free - isn't it?

It is - in the sense that you will NOT owe taxes today on the $40k of your cash-out and not even on the $10k left in your hands. For tax purposes, nothing happened.

The bad news is that, tax-wise, really nothing happened. Your investment in the house, officially called tax basis, did not go up. You have a bigger loan, but not a bigger tax basis. 

Why is this important? Because your capital gain when you sell this property will be calculate against your tax basis and NOT against your mortgage as many investors expect. In effect, you will end up paying tax on your refi cash later on, when you sell the property. 

3. A confusing example (sorry)

Let's assume you sell the property I used in my earlier example for $150k. For simplicity, ignore closing costs and depreciation. Your new mortgage is $120k, so you walk away with $30k cash. Your initial down payment was $20k. "Common sense" suggests that you owe taxes on $30k - $20k = $10k. Right? Wrong!

You owe taxes on $150k (sales price) - $100k (purchase price) - $30k (rehab) = $20k! No, I'm not kidding. You owe taxes on $20k.

But - what the heck - this is highway robbery! Why did my taxes double? I did not make $20k! Hmm, yes you did. Let's count all the cash you ever put in: $20k down payment + $30k rehab = $50k. Let's count all the cash you ever received: $40k at refi + $30k at sale = $70k. What's the difference? Yep, 20k.

But, but, but... I only have $10k in my hands now! True. AND you also had another $10k from refi - remember? It was "tax-free" back then. It is taxable now. No free lunch.

4. The other cash-out refi: property appreciation.

In another scenario, you do not need to rehab your property. It's in good shape as is. But you owned this property for a few years, and it went up in value since you bought it.

Similarly, you can get a bigger loan now. Similarly, you receive cash at closing. Similarly, you do not pay taxes on this cash today. Similarly, it will still become taxable when you sell. Allow me to spare you another long example.

5. Interest deductibility caveat.

Cash refi comes with a hidden trap for the unwary. When you make payments on a mortgage against an investment property, the interest is always deductible. Everybody knows. 

Everybody is wrong, sorry. It is not always deductible. It is only deductible if the proceeds of the loan were used for business/investment purposes. For original loans, it's never a problem: the entire loan was used to buy the property, so it's 100% business use. 

With cash-out refinance, it's not that simple. What did you use the cash for? Business purposes or personal spending? In my example above, your new $120k loan paid off the original $80k loan, reimbursed a $30k rehab and had $10k left. The $80k and $30k are business use ($30k with an asterisk, but it's too technical to discuss here). $10k - depends. 

If you spend this $10k on a nice vacation, it's a non-business use. You have to calculate a business use ratio before deducting your interest on this loan. Not the entire interest is deductible, but only 11/12 of it ($110k business use of the $120k total loan).

What if you used this $10k to buy your next property? Ahh, glad you asked. 11/12 of the interest is deductible against your first property, and the other 1/12 is still deductible, but against your second property. Aren't taxes fun? Don't answer.