A mortgage refinance isn't cheap or free, and the costs can sometimes outweigh the overall savings. Just determining if you'll break even with the costs isn't the whole picture, though. To really understand the numbers, you have to figure out how the taxes work.

Tax deductions and refinancing

The IRS allows you to deduct the interest paid on up to $1 million in mortgage debt, on either your primary or secondary home, or the two combined. So if you have a $750,000 mortgage on your primary home and $250,000 mortgage on a vacation home, you can deduct all your mortgage interest.

That doesn't change after refinancing, so you can refinance one or both mortgages and still deduct all your mortgage interest, as long as the combined mortgage principle does not exceed $1 million for a couple, or $500,000 for a single filer.

Tax rules for cash-out refinancing

There's a special wrinkle that affects cash-out refinancing, though. To be tax-deductable, mortgage debt must have been used to "buy, build or improve" your home or second home. So if you do a cash-out refinance and use the funds for some other purpose than home repairs or improvement, they're no longer qualified mortgage debt.

Instead, funds obtained through a cash-out refinance and used for purposes other than home repairs and improvement are considered a home equity loan for tax purposes. Interest paid on home equity loans is still tax-deductible, but only up to a maximum of $100,000 in debt for a couple, $50,000 for a single.

For example: Jenny is a single homeowner who owes $200,000 on her mortgage. She takes a cash-out refinance for $275,000 and uses the additional $75,000 to build an addition onto her home. The mortgage interest paid on the full $275,000 is still tax-deductible because all the proceeds were used to either buy, build or improve the home and she's still below the $500,000 limit for single homeowners.

However, suppose that instead of using the $75,000 for home improvements, she used it to put her two children through college. In that case, she could deduct the mortgage interest paid on only $50,000 of the new debt, which is the maximum allowed on home equity debt for a single homeowner. So the interest on $250,000 of her refinanced mortgage would be tax-deductible, and the portion on the other $25,000 would not.

Refinancing to pay off debts

As noted above, interest paid on mortgages is generally tax-deductible, while interest paid on other debts typically is not. So you can use a cash-out refinance to convert interest paid on credit cards and other non-deductible debts to tax-deductible interest by rolling it into your mortgage. Mortgage rates are typically lower than the rates charged on other types of interest as well.

Funds borrowed through a cash-out refinance and used to pay off other debts are considered a home equity loan for tax purposes, so they're subject to the limits noted above. Single persons can deduct the interest paid on up to $50,000 borrowed for debt consolidation, while couples can go up to $100,000.

Tax Deductibles and points

In the same year that you refinance, you can deduct the discount points you used to get a reduced mortgage rate. Unlike points on your first mortgage, these points must be deducted over the life of the loan. So, if you have a 15-year mortgage, you need to deduct 1/15 of the points per year.

If you have refinanced more than once, you can deduct unclaimed discount points from an earlier refinance if you haven't already taken advantage of them. For example, say you refinanced in 2008 and paid points and began deducting 1/15 of these points in the following years. If you refinanced again in 2010 to take advantage of good rates or you sold your house, you could take advantage of the unused portions of the points at that time.

Mortgage interest and itemizing deductions

Something to keep in mind is that refinancing your mortgage can significantly reduce your total tax deductions. Refinancing to a lower mortgage rate means you'll be paying less interest, which means you'll have less mortgage interest to deduct when tax time comes around.

The difference can be substantial. If you've been paying 5 percent on a 30-year mortgage loan and refinance to a 15-year fixed-rate mortgage at 3 percent, you've suddenly reduced your interest costs by 40 percent.

Refinancing to a shorter term also means that your interest costs will fall more quickly over the years to come as well.

For many borrowers, the mortgage interest deduction is what makes it practical for them to itemize deductions in the first place. So unless your mortgage interest and other deductions exceed what you'd get with the standard deductions (2015: $6,200 single, $12,400 couple, $9,100 head of household), there's no point in itemizing.

You'll still likely save money overall by reducing your interest costs, but you don't want to be surprised at tax time by not being able to take as much of a deduction as you had been expecting.

Confused? Don't worry - your tax advisor will be happy to help clear things up. The short of it is that refinancing can help you manage your tax liability and can provide opportunities to save money that you may not have realized.

Published on November 10, 2015