Cash-out refinance taxes: loans, interest tracing and points

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: Cash from a cash-out refinance isn't taxable income, because you have to pay it back. Whether the interest is deductible depends on how you spend the money, not on which property secures the loan. Rental and investment uses can be deductible; personal uses usually aren't. Points on a refinance are generally amortized over the loan's life.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

Refinancing a rental to pull out equity can feel like free money. In a sense it is, at least for tax purposes: the IRS doesn't tax borrowed money. But a cash-out refinance has two tax questions that trip people up. First, where does the interest go? Second, what happens when you finally sell? Lavish Larry has answered both incorrectly. Frugal Fran has a spreadsheet.

CPA Warning Label: Interest deductibility follows how the money is used, not the collateral. Refinance proceeds spent personally produce nondeductible interest, and debt doesn't reduce your gain on sale.

Why loans aren't income

Income is an accession to wealth. A loan comes with an equal obligation to repay, so your net worth doesn't change when you borrow. That's why loan proceeds aren't income, whether the loan is a first mortgage, a HELOC or a cash-out refinance, and whether the cash exceeds your basis or not.

Three related points:

• Basis doesn't change. Refinancing doesn't increase or decrease your property's adjusted basis.
• Debt doesn't reduce gain. When you sell, your gain is the sale price minus adjusted basis. Paying off the loan from the proceeds doesn't change that, so heavily refinanced properties can produce a tax bill larger than the cash you get at closing.
• Forgiven debt can be income. If a lender later forgives part of the loan, cancellation-of-debt income may result, subject to exclusions.

For a personal tracking view, a refi changes your personal balance sheet: cash goes up, debt goes up, and net worth stays the same.

Interest tracing rules

Treas. Reg. 1.163-8T allocates debt, and its interest, according to how the proceeds are used. The collateral doesn't control. Interest is then deductible (or not) based on that use:

Practical tracing rules from the regulation:

• Deposit the proceeds in a separate account. If you spend from it within 30 days of the deposit, you can treat the spending as coming from the loan proceeds.
• In a mixed account, the regulation uses an ordering rule: money is generally treated as spent from loan proceeds first.
• Money sitting unspent in savings is treated as an investment, so its interest is investment interest until spent.
• Repayments are applied first to the personal portion of the debt.

Using proceeds personally

Interest on refi money spent personally isn't deductible, even if a rental secures the loan. If you refinance your home instead, a different rule applies: home mortgage interest is deductible only on acquisition debt, meaning debt used to buy, build or substantially improve that home, up to $750,000 of debt ($375,000 if married filing separately). Home equity debt used for other purposes isn't deductible as mortgage interest. The One Big Beautiful Bill Act made these limits permanent (as of Oct 2026; see Pub. 936). But tracing still works in your favor here: interest on home-secured debt spent on a rental is rental interest.

Personal spending from a refinance may still be the right call. Paying off 24% credit card debt with a 7% loan makes financial sense even without a deduction. Some FIRE investors use rental equity to fund a cash cushion instead of selling stocks in a downturn. Just keep the deduction expectations accurate.

Points amortization

Points paid on a refinance are generally not deductible all at once:

• Rental refinance. Points and loan costs are amortized over the life of the loan. On a 30-year loan, $6,000 of points is $200 a year. If you refinance again or sell, the unamortized balance is generally deducted then, unless you refinance with the same lender, in which case it's usually added to the new loan's amortization.
• Home refinance. Points are also generally amortized over the loan's life (Pub. 936). An exception allows a current deduction for the portion of points tied to proceeds used to improve the home.
• Other closing costs on a rental refi, such as the appraisal, title and recording fees for the loan, are also amortized over the loan's life. Costs tied to buying the property, not the loan, go into basis.

Example

Illustration (made-up numbers): Frugal Fran owns a rental worth $500,000 with a $150,000 loan. Its adjusted basis is $200,000. She refinances to a new $375,000 loan at 7%, paying $7,500 in points. She uses the money like this:

• $150,000 pays off the old loan (rental).
• $150,000 is the down payment on a second rental.
• $67,500 goes to personal uses: $40,000 for a car, $27,500 for a kitchen remodel at her home.
• Closing costs: $7,500 (points, amortized).

The points are amortized: $7,500 ÷ 30 = $250 a year. The kitchen remodel is at her home, but the debt is secured by the rental, not the home, so it isn't qualified residence interest. It's personal interest. If she'd taken a HELOC on her home for the kitchen, that interest could have been deductible on Schedule A.

Lavish Larry refinances the same way and deducts all $26,250 of interest on Schedule E "because the loan is on the rental." The tracing rule disagrees by $4,725 a year, plus part of the points.

Fran's larger future issue: if she sells rental 1 for $520,000, her gain is $320,000, while she nets only about $145,000 after paying off the $375,000 loan, before selling costs. A 1031 exchange can defer that, but she'll need to replace the debt or add cash to avoid boot. See 1031 boot.

What changes at sale or a 1031

The refinance has a long tail. Three situations come up often:

• Selling the property. The loan is paid off at closing, but your gain is based on adjusted basis, not the loan. Any unamortized points on a rental loan are deducted in the year of sale. Depreciation recapture is taxed at up to 25%, and the rest of the gain at long-term rates. See selling a rental.
• A 1031 exchange. If the replacement property's debt is less than the debt paid off, the difference is mortgage boot unless you add cash. A big refinance just before an exchange can also draw scrutiny, because cash pulled out right before the exchange may be treated as boot. Refinancing well before, or after the exchange closes, is usually cleaner.
• Holding until death. Heirs generally receive a stepped-up basis to fair market value under section 1014. The deferred gain and depreciation recapture disappear, and the heirs take the property subject to the debt. This is why some investors borrow rather than sell. It works, but it relies on the step-up rule staying in place and on keeping debt manageable in a downturn.

Refinancing into a higher payment raises risk as well as cash. A rental that only cash-flows at full occupancy can turn negative with one vacancy.

Before you refinance

• Decide the use of every dollar before closing, and write it down.
• Open a dedicated account for the proceeds.
• Compare the after-tax return of the new rental with the after-tax cost of the debt. See after-tax cash-on-cash.
• Keep the closing statement. You'll need it to split points, loan costs and payoff amounts.
• Model the sale. A large loan plus low basis means a tax bill larger than your net proceeds.