Cash-Out Refinance on a Rental Property: What Is and Is Not Taxable
A cash-out refinance is the closest thing to tax-free money in real estate. You extract equity, you owe no tax, and you keep the property.
That is genuinely true, and it is why the strategy is so widely used. But four things change when you refinance, and three of them get handled incorrectly on most returns.
The Proceeds Are Not Income
Loan proceeds are not gross income under IRC Sec. 61 because they carry a repayment obligation. This holds regardless of the amount extracted or how much the property has appreciated.
An investor who bought a property for $340,000, watched it appreciate to $720,000, and refinances at 75% loan to value receives $540,000 in loan proceeds. After paying off a $210,000 existing loan, $330,000 in cash arrives with no tax consequence.
This does not change your basis. Basis remains original cost plus capitalized improvements less accumulated depreciation. It does not increase because you borrowed against the property, and it does not increase because the property appreciated.
Interest Deductibility Depends on Use
This is the most commonly mishandled item. Under Treasury Regulation Sec. 1.163-8T, interest is allocated based on how the proceeds are used, not on what secures the loan.
Proceeds reinvested into another rental produce interest deductible against that rental. Proceeds used to pay off a personal credit card produce personal interest, non-deductible. Proceeds used to fund a business produce trade or business interest. Proceeds used to buy stocks produce investment interest, deductible only against net investment income under IRC Sec. 163(d).
A refinance producing $330,000 of proceeds, of which $240,000 goes into another rental and $90,000 pays for a home renovation and a vehicle, produces interest that is roughly 73% deductible against rental income and 27% subject to other rules or non-deductible.
The refinanced property's Schedule E should reflect only the traced portion. Deducting the entire interest against the rental because that is where the loan sits is a common error and is wrong.
Points and Loan Costs Amortize
Points paid to obtain a rental property refinance are not currently deductible. They must be amortized over the life of the loan under IRC Sec. 461(g). Points on a refinance of a personal residence follow different rules, but rental refinances are clear.
On $9,600 of points on a 30-year loan, that is $320 per year.
Where a prior loan being refinanced still carries unamortized points, those remaining points are generally deductible in full in the year the old loan is retired, since the debt to which they related no longer exists. This is a real deduction that gets missed routinely, particularly for investors who refinance every few years.
Other loan costs, appraisal, title, lender fees, and origination charges, are also amortized over the loan term rather than deducted currently or added to basis.
The Basis Gap Grows
Each refinance widens the gap between what you owe and what you can deduct. After three refinance cycles, an investor may have $90,000 of remaining basis and $480,000 of debt on a $650,000 property.
On a sale, gain is measured against basis. The taxable gain here is roughly $560,000 while the cash after debt payoff is roughly $130,000. The tax at blended recapture and capital gain rates can approach or exceed the cash received.
This is the structural risk in a refinance-heavy strategy, and it has a well-established answer. Under IRC Sec. 1031, a like-kind exchange defers the entire gain. Exchange rather than sell, and continue exchanging, and the gap never comes due during your lifetime. At death, heirs receive a stepped-up basis under IRC Sec. 1014 and the deferred gain disappears entirely.
That is the actual endgame of buy, refinance, hold. Investors who follow the first three steps and then sell without an exchange discover the arithmetic at closing.
Refinancing Does Not Reset Depreciation
Depreciation continues on the original schedule regardless of refinancing. A property placed in service in 2016 on a 27.5-year schedule continues on that schedule after a 2026 refinance. The loan is irrelevant to depreciation.
Capital improvements made with refinance proceeds are a separate matter. Those are added to basis and depreciated on their own schedule from their own placed-in-service date. A $140,000 renovation funded by refinance proceeds creates $140,000 of new depreciable basis, and a cost segregation study on that improvement can accelerate a large share of it.
This is the productive way to use refinance proceeds from a tax perspective: reinvest into improvements or additional property, generating new depreciable basis, rather than extracting for consumption.
Worked Example: Refinance and Redeploy
An investor owns a rental purchased for $380,000 in 2018, now worth $690,000, with $198,000 remaining on the original loan and $312,000 of adjusted basis after depreciation.
A cash-out refinance at 75% loan to value produces $517,500 of loan proceeds. After retiring the $198,000 existing loan and $11,000 of closing costs, the investor receives $308,500 tax free.
Unamortized points of $4,200 from the original loan are deducted in full in the refinance year. New points and loan costs of $11,000 amortize over 30 years at $367 annually.
The investor deposits the $308,500 into a dedicated account and uses $290,000 as the down payment on a $1,160,000 fourplex, with $18,500 retained for reserves. Interest on 94% of the new loan is traced to the fourplex acquisition and deductible against that property.
A cost segregation study on the fourplex produces $242,000 of first-year deduction. The investor qualifies as a real estate professional and uses it against other income.
No tax on $308,500 extracted, a $242,000 deduction created, and interest fully deductible. The basis gap on the original property grows, which the investor plans to resolve through a 1031 exchange at eventual disposition.
Frequently Asked Questions
Do I pay tax on cash-out refinance proceeds?
No. Loan proceeds are not gross income under IRC Sec. 61 because you have a repayment obligation. This is true regardless of how much equity you extract or how much the property has appreciated.
Does a refinance increase my depreciable basis?
No. Basis is original cost plus capitalized improvements less accumulated depreciation. Borrowing against appreciation does not change it. Only capital improvements funded with the proceeds create new depreciable basis, on their own schedule from their own placed-in-service date.
Is all the interest on a cash-out refinance deductible against the rental?
Only the portion traced to rental use. Under Treas. Reg. Sec. 1.163-8T, interest follows the use of proceeds. Amounts used personally produce non-deductible personal interest even though a rental secures the loan. Deducting the full interest on Schedule E is a common error.
Can I deduct the points on a rental refinance?
Not currently. Points on a rental refinance are amortized over the loan term under IRC Sec. 461(g). However, any unamortized points remaining from the loan being paid off are generally deductible in full in the year of the refinance, which is frequently missed.
What happens when I eventually sell a heavily refinanced property?
Gain is measured against basis, not debt. After multiple refinances the taxable gain can exceed the cash you receive at closing. A 1031 exchange under IRC Sec. 1031 defers the gain entirely, and holding until death gives heirs a stepped-up basis under IRC Sec. 1014.
Related Reading
Trace the Proceeds Before You Spend Them
The deduction on a refinance is decided by where the money goes, and it is much easier to get right in advance. Bring us your refinance plan and redeployment target.
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