Pulling $147,000 out of a house you paid $120,000 for feels like it ought to be a taxable event. It is a large sum arriving in your account from a property that went up in value, which is most people’s mental picture of a gain. The IRS looks at it differently, and the reason is worth understanding, because it also explains the one part of a cash-out refinance that genuinely can cost you a deduction.
Is the cash from a cash-out refinance income?
No. The IRS puts it in a single line in its small business guide, under a heading listing items that are not income: “Money borrowed through a bona fide loan is not income” (Publication 334).
What makes it not income is the string attached. A debt is money you “are legally obligated to repay a fixed or determinable amount at a future date” (Topic 431). You have not gained anything yet. You hold cash and an equal obligation to give it back with interest.
The same page shows what happens when that obligation goes away. If a debt is “canceled, forgiven, or discharged for less than the amount owed”, then “the amount of the canceled debt is taxable”. That is the mirror image: the borrowing was not income because you owed it, so being let off owing it is.
What does the refinance actually hand back?
The example is the BRRRR calculator’s own deal. A house bought at $120,000 with 2 percent closing costs, $35,000 of work, and $800 a month of holding costs over a four month rehab.
| Amount | |
|---|---|
| Purchase price | $120,000 |
| Closing costs at purchase (2%) | $2,400 |
| Rehab budget | $35,000 |
| Holding costs ($800 a month for 4 months) | $3,200 |
| All-in cost | $160,600 |
These are example figures, not a forecast for any market.
Finished, the house appraises at $200,000. The refinance is written at 75 percent of that valuation, which is a $150,000 loan, and 2 percent of the loan goes to closing costs.
| Amount | |
|---|---|
| All-in cost | $160,600 |
| New loan at 75% of the $200,000 valuation | −$150,000 |
| Refinance closing costs (2% of the loan) | +$3,000 |
| Cash left in the deal | $13,600 |
So $147,000 reaches you, $13,600 of your money stays in the house, and you now owe $150,000 on a property worth $200,000. The whole $147,000 is untaxed, and none of the $39,400 of equity the rehab created is taxed either, because you have not sold anything. A BRRRR worked end to end runs the same deal through all five steps, and the refinance waiting period covers how soon a lender will write that loan.
What is taxable on this house, then?
The rent. Once the house is rented, you report what it collects and deduct what it costs to run. Publication 527, the one written for residential landlords, lists the usual deductions: advertising, auto and travel, cleaning and maintenance, commissions, depreciation, insurance, interest, legal and professional fees, management fees, repairs, taxes and utilities (Publication 527).
Depreciation is the line people miss, and it is the one large deduction that never costs you a dollar in cash. How rental property depreciation works walks through the figure and the years it runs over.
Does the bigger loan mean a bigger interest deduction?
Here is where a cash-out refinance can cost you something, and it depends entirely on where the cash goes.
Publication 527 says plainly that “You can deduct mortgage interest you pay on your rental property.” Then it adds the limit: “When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense.”
Its own example is a loan balance of $100,000 refinanced into a new loan of $120,000, with the extra $20,000 used to buy a car. The publication says the points on that $20,000 “would be treated as nondeductible personal interest”.
Read that against a BRRRR and the shape of the rule is clear. Interest follows what the borrowed money was spent on, not which property secured it. Cash from this refinance that goes into the next rental is a different case from cash that pays for a car, and the arithmetic of splitting a loan between uses is not something the calculator does. That one belongs with a tax professional before you file.
What the new loan does to the numbers
Tax aside, the refinance has already changed the deal. The $150,000 loan at 7.5 percent over 30 years costs $1,049 a month. Against $2,400 of rent, an 8 percent vacancy allowance and $876 a month of operating costs, the house clears $283 a month, which is $3,398 a year on the $13,600 still in it.
The lender’s own test, debt service coverage, lands at 1.27. That is net operating income divided by the loan payment, and each lender sets its own minimum. The calculator draws its line at 1.25, so this deal clears the bar with very little to spare.
Pull more cash out and every one of those figures moves the wrong way together. A refinance at 80 percent of the same valuation is a $160,000 loan, which takes another $70 a month out of the cash flow, leaving $213, and drops the coverage ratio to 1.19, under the calculator’s line. That is the real trade in a cash-out refinance, and it has nothing to do with tax: the more of your money you get back today, the less the house earns while you hold it. The calculator’s Loan to value box, under Refinance on the Inputs tab, is where you watch the two move against each other.
What to take to a tax professional
Three things on this deal are worth a paid half hour: how the $147,000 is split between uses and what that does to the interest, what the rehab spending adds to your basis rather than being deducted in the year you spend it, and what the eventual sale looks like once depreciation is recaptured. Depreciation recapture covers the last of those.
The refinance itself needs no tax planning, because nothing taxable happened. Run the next loan amount through the BRRRR calculator and watch the cash flow and the coverage ratio, not the cash you walk away with.