When the Federal Reserve slashed interest rates to near zero in response to the coronavirus crisis, everyone decided that it was a perfect time to refinance their mortgage. There were so many refinance requests that lenders had to artificially raise rates in order to lessen demand and give them a chance to keep up. Rates bounced around quite a bit but have spent the rest of the year near historic lows.

Because of this, a lot of people have refinanced their mortgages this year. If this is news to you, you should really look into refinancing because with a lower interest rate you could save thousands of dollars over the life of your loan. 

What Is A Cash-Out Mortgage Refinance?

A choice you have to make when refinancing is how much you want your new mortgage to be for. One option is to borrow the same amount as you currently owe and just enjoy the benefits of a lower interest rate. 

The second option is to take advantage of any equity you have in your home and take out a bigger mortgage. Borrowing more than your original mortgage balance allows you to pocket some cash in the process. That’s called a cash-out refinance because you are essentially taking cash out of your home’s equity.

How Does Cashing Out Equity Affect Your Housing Allowance?

Doing a cash-out refinance can affect your mortgage’s eligibility for the housing allowance. Usually, mortgage and interest payments are eligible for federal income tax exemption through the clergy housing allowance. They are eligible because you are using that money to provide a home.

The big question with a cash-out refinance is What are you doing with the cash? If you use it to remodel your bathroom or build a deck, then you are still using the money to provide a home. As such, your entire mortgage payment still qualifies for the ministerial housing allowance.

What if you use the money for something non-home related? What if you use it to pay down debt or send a child to college? This is when it gets complicated. If part of your mortgage is paying for non-housing expenses, then part of it is not eligible for the pastor’s housing allowance.

How To Calculate Housing Eligibility For A Cash-Out Refinance

Luckily, mortgage payments are not an all-or-nothing deal. Using some money for non-housing things doesn’t disqualify your entire mortgage payment from the ministerial housing allowance. Just a portion of it. You can claim a pro-rata portion of your payments as qualified expenses for the housing allowance. 

Let’s say you owe $180k mortgage and your house is worth $250k. You decide to refinance and borrow $200k so that you can pay off your student loans. Your new loan is broken down into $180k of housing costs and $20k in student loan costs. Only 90% of the mortgage was used for housing costs, so only 90% of your mortgage payment is eligible for the clergy housing allowance.

If your principal and interest payment is $1,000 a month, then only $900 of that qualifies for the housing allowance. Most of us don’t only make principal and interest payments, though. My monthly mortgage payment also includes escrow money for property taxes and homeowners insurance. 

For this example, let’s say you’re like me and your monthly payment is $1,400, with the extra $400 covering insurance and taxes. Does that mean that you can only claim $1,260 for the housing allowance (90% of $1,400)? 

Nope! Your property taxes and homeowners insurance are 100% eligible for the housing allowance even if your mortgage principal and interest payments are not. For accurate calculations, you have to break down your monthly payment into the portion that is used 100% for housing expenses (insurance and taxes) and the portion that is only partly used for housing expenses (mortgage principal and interest). 

In this example, only $900 of the principal and interest payment is eligible for the housing allowance while the entire $400 for taxes and insurance is. So, $1,300 of the $1,400 monthly payment counts towards the housing allowance. If you just do 90% of the whole payment, you’ll be selling yourself short and paying some unnecessary taxes.

How The IRS Verifies Accuracy

After explaining this to a friend, he asked me what happens if you just claim it all. What happens if you take cash out of your mortgage for non-housing expenses but continue to include 100% of your payment as a housing allowance?

In most cases, nothing. The IRS does not check up on you and verify the accuracy of your housing allowance. That is until you get audited. If you cheat on your housing allowance, they may uncover it in an audit. 

But just because the IRS isn’t watching you doesn’t mean that God isn’t. It isn’t necessarily a matter of whether or not you’ll get caught, it’s a matter of character. You get to decide for yourself how you want to proceed.