While common sense dictates that it is money you should pay tax on, that is not how the law views it. [by law I mean federal income tax law in 26 USC, I have no idea how the various state tax things]  This tax on the money you get is inevitably taxed however.  This can happen in a number of ways, though the most difficult to understand circumstance comes when the property is foreclosed upon.  This results in what is referred to as 'phantom income'.  A sale results in a capital gain [loss] and is a taxable event.  A foreclosure is a 'forced sale', but a sale none the less.  The arithmetic that goes with this is like a tree with many branches, and can have many different results.  The only time there is truly no tax on a loan is when you pay it back in a timely fashion, and even that has tax consequences.  At present there is a law that lets homeowners off the tax hook when they lose their primary residence, but as far as I know it expires 12/31/09 [look for it to be renewed in an election year].  The real answer is that all the foolish people who 'cashed out' when they refinanced their homes, are suffering now because of the tax laws, and because they have wound up givng he banks their homes.

The money you take out on a cash out refinance is not taxed until that home is sold or foreclosed.

The refinance in not a taxable event, it may create more taxes at the time of sale.

I could explain this process here but it is best to speak with your tax advisor regarding your personal circumstances and since I am not an accountant I really can't explain the details but I can tell you the refinance itself will not create taxes at the time you close on the new loan and will not be an issue during the same calender year unless it is sold.

Your tax advisor should be able to confirm this and explain your personal situation to you so you know what will happen at the time of sale of the residence.

I feel that I am especially qualified to answer this question as  I am not only a licensed mortgage advisor (CA real estate license); in addition, I am also a California Registered Tax Preparer and as a bonus - you are asking a question on my two favorite subjects: mortgages and taxes!

My answer, however, applies to IRS 1040 returns so this question is applicable to any homeowner filing a federal 1040 return.

A cash-out refinance is where the homeowner (borrower) conducts a refinance on the property and receives an actual cash distribution in addition to the refinancing of the existing loan.

Example:  Your existing loan is $100,000 and you refinance that amount and receive an extra $25,000 cash to pay for your daughter’s wedding.  Your question is focused on the $25,000 – how is that amount treated by the IRS?

According to IRS Publication 936, Home Mortgage Interest Deduction, the loan must be secured, you are legally liable for the loan, you claim the deduction on Schedule A of the Form 1040 and the home is a qualified home for which you claim an interest deduction.

The IRS does not distinguish a cash-out as a non qualified interest deduction.  There is no reference made to a cash-out as it is viewed as wholly integrated into the refinance.  Therefore, in the above example, the borrower would receive a Form 1099-I from the lender indicating the interest paid for the tax year from the entire amount of $125,000.

Keep in mind that this is a general answer as there are special situations such as ministers, military, divorce, separation, pre-paid interest, etc.

The above information is topical and I encourage you to consult with your tax professional for your specific situation.

I will preface by saying that i am not a tax professional.  However, cash out taken on a home loan is not currently taxable under the tax code as it is borrowed money.  Because the funds are borrowered and you must make a repayment with interest , it is not treated as income.  If you use the analogy that your boss pays you a salary for doing work, you dont owe him any repayment of the funds with any interest.  He is giving you payment in exchange for an exchange of services.  When you are borroweing funds this is not the case.  Another example is that when you liquidate funds in an investment you have to pay tax on the gains.  this case you ar borrowering funds vs liquidating.  It is similar to a Variable annuity where tax code allows you to borrow against your investment tax free.  In this case, in fact, the interest paid on the loan may be tax deductible, depending on what the funds were used for and the cost basis in the home and the use use of the home.