How does Cash out Refinance accounted from Tax Purposes

[Raman Bindlish]

I have a question with respect to Cash-Out Refinance.

Background and some context

- We bought a duplex last year and put in some money into it.

- It lost money this year due to an eviction and we ended up doing a major rehab (putting in more capital into the property). We have net negative cash flow in both financial years of operation.

- Now, we believe we should be able to refinance and get some cash out to pay ourselves back for rehab money and deploy the capital somewhere else.

- We do not plan to sell the property in short term and just cash flow it for longer term and build equity. 

My questions:

- How will the cash out of refinance seen from tax purposes? Does it adjust with losses due to investment into the property? What if the cash from refinance comes back in a different financial year?

- Or does it reduce our base for capital gains when we sell as we are taking the money out from original investment?

- How is any rehab budget accounted in final capital gains if we sell the property after a long time?  As in reality we are just taking our rehab budget out of the property and adding it to loan value, how best to show it in tax paperwork to minimize the impact overall?

Look forward to advice from experienced investors on how to best manage this situation and maximize the tax savings. I do not care if we save tax now or later when we sell after let's say 10 years.

[Jenny Bayless]

Hi @Raman Bindlish

That's correct- the only tax implications you will have related to the cash out refi would be you'll likely have a larger interest expense, and you will need to amortize your loan costs over the life of the loan.  

Just remember that you are not earning the money you are taking out as part of a refinance, rather you are just borrowing it, and you will still owe this back to the bank as part of your mortgage (you are just paying it back incrementally via your mortgage payments).

Think of it this way for example: You have a house worth $100,000 and a mortgage worth $50,000.  All else equal, your equity is $50,000 (assets minus liabilities).  Now, if you in turn do a cash out refi for an $80,000 loan and pull $30,000 cash out, you now have $100,000 house (asset), $30,000 in cash (asset), $80,000 in mortgage debt (liability), and a net worth of $50,000.  It was nothing but a shift amongst assets and liabilities.