When it comes to your home, carry a big mortgage. Don’t keep the cash in your walls. That’s empty equity that could be used for additional investments. But, if you do refinance and take the cash tax-free, be careful how you use the profits, because the IRS may come knocking  if you aren’t careful. Here’s why.

Unlike most debt, a home mortgage is the cheapest money you can borrow, and sometimes it’s the only debt that’s tax-deductible. You could invest the refi proceeds and earn a higher return in another investment vehicle. That’s why it makes sense to take the cash out of your home and invest it. However, this strategy only makes sense if you can find an investment return that’s greater than the after-tax cost of the debt. Here are two investments to avoid . . .

The IRS knows that you get a big tax advantage with your home mortgage. To prevent you from double-dipping, there are two types of investments that you can’t buy with refinance proceeds: tax-deferred or tax-free investments. This means you cannot use your mortgage refi money to buy tax-deferred annuities or tax-free municipal bonds. The IRS doesn’t want you to have a tax deduction on your mortgage, and then use the money to invest in securities that let you earn interest or profits that aren’t taxable.

How do you get around it?

The way around this is in how you use your money. There isn’t a restriction against variable annuities and muni bonds, even when you have a mortgage, if you can show that the money you used to buy these investments didn’t come directly from your mortgage refi. In other words, the money used for these investments must come from your earned income or some other source. Otherwise, you’ll lose the tax deduction on your mortgage interest!

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