Mortgage Refinance and Taxes

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One of the great benefits of owning your home is the large income tax deduction you're allowed for mortgage interest. However, when you refinance your mortgage loan into a lower interest rate, you'll pay less interest. Lowering interest payments also means shrinking that juicy tax deduction.

Acquisition vs. Equity Debt

What happens to your taxes if you do a cash-out refinancing? It depends on what you use the extra funds for. First or second mortgages that are used to buy, build, or improve your home are termed "Home Acquisition Debt" (HAD) by the IRS. If you refinance to get either better rates or more favorable terms, you're accumulating HAD. If you do a cash-out refinance, the money that is not used for home improvements is considered Home Equity Debt (HED).

Acquisition Debt is fully deductible, up to $500,000 for individuals, and $1,000,000 for married couples who file joint returns. The deduction limit for Equity Debt is $100,000 more than the existing debt at the time of your refinancing. If you have a mortgage with a balance of $200,000, you can refinance into a $300,000 loan (assuming your home appraises for at least that much now), and still deduct the full interest payments from your taxes. The interest paid on any balance higher than $300,000 is not deductible at all.

Getting the Point

You can take out points on your mortgage in order to push down the interest rate even further. Points are generally tax-deductible, like interest payments-except when you're refinancing.

Some points are charged for lender services (not tax deductible), and others for prepaid interest (deductible). In general, the points are prorated throughout the life of the loan; so if you paid $4,000 in points for your 30-year loan, but $1,000 of that was for services, you can deduct 1/30th of $3,000, which is $100 a year.

But if part of the refinancing funds were used for home improvements, a portion of the points can be deducted immediately. For example, if you took a $100,000 mortgage loan, you could pay off an existing $80,000 mortgage and use the rest for home improvements. In this case, you can deduct 20 percent of the points the first year, and spread the remainder throughout the next 29 years.

One more twist: If you refinance again, all points that have not yet been deducted are applied in that one year, regardless of whether the new loan carries any points.

As you can see, refinancing your mortgage can make tax time a lot more interesting. It pays to do a tax code cram session before deciding how to refinance, so you won't get caught unprepared when you file your next tax return.

The IRS has blessed homeowners by letting them deduct points on their taxes. However, there's a subtle difference between the amount deductible on a mortgage refinance versus the amount you can claim on a traditional home mortgage.

Refinancing taxes made easy

When you purchase your home, you'll jump for joy knowing that the points you'll pay are deductible in the tax-year in which you made the buy. For example, if you paid one point on the origination fee of your brand new $350,000 house, you'll have a hefty $3,500 tax deduction to write-off when April 15th comes around.

It's a different ballgame, however, when you refinance your mortgage. In the above case, if the same homeowner refinances his mortgage after two years, the deduction for the amount he paid in points will be amortized over the course of the loan. If he refinances and pays 2 points on a new $300,000 loan, his tax deduction of $6,000 under the refinancing scenario-(2 percent x $300,000)-would be amortized over 30 years (the term of the new loan). The math in this case ($6,000/30) results in a tax deduction of $200 per year for 30 years.

The silver lining

Don't let this IRS stipulation rain on your tax break parade. Uncle Sam won't make you wait 30 years to claim the entire deduction. If you decide to refinance again, or if you sell the house, you can write-off the unclaimed portion of the deduction. In the above example, if the homeowner decides to sell his house after only two years after refinancing his mortgage, he can claim the remaining $5,600, since he had deducted only two years at $200 on his taxes.

Paying points on a home loan can be a great move for people who don't plan on moving. Just be aware that the tax deduction on a mortgage refinance won't be as immediate as a purchase loan. One way or the other, though, you'll get the deduction. As is usually the case with most things monetary, it's just a matter of time.

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