There are a number of readers who eventually send in the same questions that led me to this column. I am not sure why there is as much confusion over this financial tool as there is but nevertheless I am going to try to clear up some of the confusion. Much of it has to do with taxation and I shall start with that subject.
Many years ago I was working with a notable celebrity who was having tax problems (not my field) and was in need of some mortgage counseling as this borrower's credit had suffered. As April 15th came closer I was asking about the current income and found that it was derived by this person by adding up the deposits in the check book. I knew that earlier in the previous year there had been a cash out refinance and I asked if that was included in the addition of deposits from the check book. Much to my horror it had been and the belief was that a refinance was income and therefore a taxable event. NO, cash out refinance is a loan to yourself from your equity and never a taxable event. In the aforementioned case this had been going on for years and we quickly amended years of tax returns to relieve an on going IRS probe.
A cash out refinance doesn't affect your property taxes as it doesn't change the value of the property. Some states do have taxes on refinancing (New York for one) but it isn't a tax associated with the change in the value of the property. Property taxes are certainly affected by construction to the property but the loan isn't the trigger, the building permits are.
Can a cash out refinance end up being a taxable event in any way? When you sell your primary residence, if you have lived there for the past two years (simplified for the example) you get $250,000 exclusion if you are single and a $500,000 exclusion if you are married on the profits. You calculate the profits by taking the net sales price and subtracting the cost of the property and the cost of any improvements or additions you made. If your profit exceeds the $250,000 or $500,000 stated above you owe capital gains on the difference. If you have subsequently pulled out most of the money from the house in a cash out refinance then you actually could end up owing money that came from the refinance. Remember, it wasn't the refinance that caused the taxable income, it was the sale.
Writers note: I am not an expert on every state's tax policy on real property so please check with your tax adviser before taking any action that could cause you to have a taxable event.
Roger Schlesinger's Mortgage Minute is heard on hundreds of radio stations and daily on the Hugh Hewitt radio show and Michael Medved shows. Roger interacts with his hosts and explores the complicated financial markets in order to enlighten his listeners and direct them along their own unique road to financial freedom.
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