How does Cash out Refinance accounted from Tax Purposes

Question

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 · Answer

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.

Raman Bindlish · Answer

Hi @Jennifer B.

Thanks for your response.

So, you are saying that cash-out from refinance is completely ignored when you file taxes. Or I got it wrong? We do not have to show it in our tax returns as any income?

-Raman

Jenny Bayless · Answer

Hi @Raman Bindlish

It is important to note you have three separate things going on here: A. An adjustment to your basis of the property (your rehab, I am assuming that all costs are capitalized in your situation, but you will want to review that) and the depreciation, B. The new loan taken out, and ultimately cash in hand due to the refi, and C. Your income/loss in the given year for taxes (passive income).  You will want to make sure to separate the costs incurred as part of the rehab, vs the costs incurred as part of your operations (i.e. property taxes, eviction costs, etc).

Please see my answers to your questions below:

1. The cash out refi will not effect your taxes.  Even if the cash from a refinance comes back in a different year, there will be no taxable impact to you (other than the change in interest rate being paid due to a higher mortgage, and the amortization of your loan costs).  The loss in income (Taxable Revenue- Deductible Expenses) will be taken care of on your tax return, and is not a part of your basis.

2. No, the cash out re-fi will not effect your asset's basis.  However, your improvements to the property will.

3. Your capital gains/loss will be calculated as (simplified):

Amount realized from the sale of the asset (less selling costs)

less: original purchase price (and some of your closing costs)+capital improvements- accumulated depreciation

Don't forget your depreciation recapture too.

Hope that this helps!