Cash-Out Refinance Tax Treatment: Deductible Interest and Debt Cap

Interest on a cash-out refinance is tax deductible only to the extent you use the new money to buy, build, or substantially improve the home that secures the loan, and only within the overall mortgage debt cap of $750,000 for most filers ($375,000 if married filing separately).¹ Any part of the cash-out you spend on credit cards, tuition, a car, or anything else outside the home produces interest that is permanently nondeductible.

What Makes Cash-Out Interest Deductible

Federal tax law sorts mortgage interest into deductible and nondeductible based on whether the underlying debt is “acquisition indebtedness,” meaning debt used to buy, build, or substantially improve a home that secures the loan.² A cash-out refinance replaces your existing mortgage with a larger one. The slice that pays off your old balance generally keeps the acquisition-debt status it already had. The extra cash on top qualifies only if you spend it on the home itself.

The same refinance can therefore generate both deductible and nondeductible interest. Pull out $80,000, put $50,000 into a new roof and $30,000 into credit card payoff, and the interest tied to the $30,000 is lost for good. Spending unrelated money on the house later does not fix the allocation.

What Counts as a Substantial Improvement

The IRS treats a project as a substantial improvement when it adds value to the home, extends its useful life, or adapts it to a new use.¹ Adding a bedroom, replacing an entire roof, finishing a basement, or installing central air conditioning qualifies. Routine upkeep does not. Patching a faucet or repainting a room keeps the home in its current condition rather than improving it, so the interest tied to that spending is not deductible.

There is one useful nuance. If minor work is part of a larger qualifying renovation, its cost gets folded into the improvement total. Painting the kitchen walls during a full kitchen gut counts. Painting them because they looked tired does not.

Soft costs count too. Architect fees, design plans, and building permits all count toward the cost of a substantial improvement.¹ If $8,000 of a $60,000 addition goes to an architect and permits, the whole $60,000 is treated as qualified improvement spending for interest purposes.

The $750,000 Debt Cap

Even when every dollar of your cash-out is spent on qualifying improvements, there is a ceiling on how much mortgage debt can produce deductible interest. For most filers, interest is deductible on the first $750,000 of combined acquisition debt across all qualifying homes. Married taxpayers filing separately are limited to $375,000 each.¹ The Tax Cuts and Jobs Act set this cap in 2017 with a scheduled expiration after 2025, and the One Big Beautiful Bill Act signed on July 4, 2025 made it permanent.³

Mortgages taken out on or before December 15, 2017 follow a higher $1,000,000 cap ($500,000 for married filing separately).² If you still hold one of these older mortgages and then do a cash-out refinance, the portion that replaces the old balance keeps the old limit up to what you still owed. Anything above that payoff amount falls under the $750,000 cap, and that cap is reduced by the older debt still outstanding.

The cap works on total mortgage debt, not per loan. If you owe $600,000 on your primary home and refinance out an extra $200,000 to rebuild a damaged garage, your acquisition debt is $800,000. Interest on the first $750,000 is deductible; interest tied to the last $50,000 is not, even though the money went into the house.

Second Homes Share the Same Cap

The $750,000 limit covers your main home and one second home combined, not each property separately.¹ A qualified home can be a house, condo, mobile home, or boat, as long as it has sleeping, cooking, and bathroom facilities. You can only designate one second home at a time.

If you rent the second home out, it counts as a qualified home only if you personally use it for the longer of 14 days or 10% of the days it was rented at fair market rates that year.¹ A second home you never rent qualifies automatically. Miss the personal-use threshold and the property is disqualified for the year entirely, which knocks all of that mortgage’s interest out of the deduction.

How the IRS Traces Where the Money Went

The IRS does not take your word for how you spent the cash-out. Federal regulations require tracing each dollar of debt proceeds to a specific expenditure, and the character of the debt follows the actual use of the funds.⁴ Most deductions fall apart at this step. If $100,000 in proceeds lands in the same checking account that pays for groceries and car loans, the IRS cannot tell which dollars reached the contractor.

The cleanest protection is to open a separate account for the proceeds and pay every improvement expense directly from it. Keep signed contracts, itemized material invoices, architect fee agreements, permit receipts, and bank statements showing transfers from that account to the contractor or supplier. Without clear documentation, the IRS can reclassify the entire cash-out as personal spending and deny the deduction.

Splitting Interest When You Used the Money for Both

When part of the cash-out went to improvements and part to personal spending, split the interest with a simple ratio: qualifying improvement spending divided by total cash-out. That percentage of the interest on the cash-out portion is deductible. The IRS uses the same method to allocate points on a refinance.¹

Say you owe $350,000 on your current mortgage and refinance into a $450,000 loan. The $350,000 that replaces the old balance keeps its acquisition-debt status. Of the $100,000 cash-out, $60,000 goes to a structural addition and $40,000 to a vacation and personal debts. Sixty percent of the interest on the cash-out portion is deductible. The other 40% is gone for the life of that loan.

Points on a Cash-Out Refinance

Points on a refinance follow different rules from points on an original purchase. You generally cannot deduct refinance points in the year you pay them; you spread the deduction evenly over the life of the new loan.⁵ Six thousand dollars in points on a 30-year refinance produces a $200 annual deduction.

There is a partial exception for cash-out refinances used on improvements. The share of points matching improvement spending can be deducted in full the year you pay them, so long as you paid with your own funds rather than rolling them into the loan.¹ Using the 60% split above, $3,000 in points would generate a $1,800 current-year deduction, with the remaining $1,200 amortized over the loan.

If you refinance again or sell before the loan term ends, any unamortized points from the earlier refinance become fully deductible in the year the old loan is paid off. This is a commonly missed deduction and can be sizable.

Claiming It on Your Return

Mortgage interest is deductible only if you itemize on Schedule A of Form 1040.¹ If the standard deduction is higher than your total itemized deductions, claiming the interest gives you no benefit.

Your lender sends Form 1098 each year reporting total interest paid on the loan.⁶ That figure covers all interest regardless of how the proceeds were used. If only part of your cash-out qualifies, you calculate the deductible portion yourself and enter the reduced number on Schedule A. The IRS does not adjust Form 1098 for you.

Hold on to the supporting documents. The standard audit window is three years, six years if you underreport income by more than 25% of gross income, and seven years for a bad debt deduction.⁷ Because this deduction stands or falls on records you control, seven years is the safer horizon.

Penalties for Overstating the Deduction

Claiming nondeductible interest as deductible creates an underpayment, and the IRS imposes penalties depending on why. For careless errors or positions without a reasonable basis, the accuracy-related penalty is 20% of the underpayment.⁸ If the IRS finds you intentionally inflated the deduction, the fraud penalty is 75% of the underpayment attributable to fraud, and you carry the burden of proving any portion was not fraudulent.⁹ Both penalties sit on top of the back taxes and interest already owed. Sloppy recordkeeping typically lands in the 20% tier, but the IRS has broad discretion, and the tracing documentation above is the most reliable protection.

1
Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction
2
Office of the Law Revision Counsel. 26 USC 163 – Interest
3
Internal Revenue Service. One, Big, Beautiful Bill Provisions
4
GovInfo. 26 CFR 1.163-8T – Allocation of Interest Expense Among Expenditures
5
Internal Revenue Service. Topic No. 504, Home Mortgage Points
6
Internal Revenue Service. Instructions for Form 1098
7
Internal Revenue Service. How Long Should I Keep Records
8
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
9
Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty