Friday, November 16, 2012

Tax Breaks for Refinancing Your Mortgage

by Bill Bischoff

Serial refinancers should take note.

With mortgage interest rates at historical lows, refinancing might be an attractive proposition–even if your last refinancing deal was not too long ago. For instance, if you refinanced in 2010 or earlier, it could be time to do it again. While you’re at it, don’t forget to collect your rightful tax deductions. Here’s what you need to know about tax write-offs when refinancing your principal residence.

Deducting Mortgage Interest After Refinancing

Say your mortgage balance is $300,000, and you decide to refinance and take out some cash by signing up for a new $335,000 15-year loan at a significantly lower interest rate. You use the extra $35,000 from the new mortgage to eliminate credit-card balances, pay off a car loan and cover some other expenses.

Assuming your home is worth at least $335,000 when you refinance (your lender will almost certainly require that to be true) and assuming you paid at least $300,000 to buy the home and make improvements over the years, your new mortgage is considered to have two separate parts for tax purposes.

The first part has an initial balance of $300,000, which equals the refinanced balance from your old loan. This $300,000 part is treated as so-called home-acquisition debt for tax purposes. All the interest on up to $1 million of home-acquisition debt can be written off as an itemized deduction on Schedule A of your Form 1040 (use Line 10). Interest on home-acquisition debt in excess of the $1 million cap is generally nondeductible.

The second part has an initial balance of $35,000, which equals the cash you took out when you refinanced. This $35,000 part is treated as so-called home-equity debt for tax purposes. Interest on up to $100,000 of home-equity debt can also be written off on Schedule A (use Line 10 here too). It doesn’t matter how you use the loan proceeds. Interest on home-equity debt in excess of the $100,000 cap is generally nondeductible.

Warning: If you’re a victim of the dreaded alternative minimum tax (AMT), you can deduct interest on up to $100,000 of home-equity debt for AMT purposes only to the extent you use the loan proceeds to pay for home improvements. In our example, you used the $35,000 of home-equity debt proceeds to pay for other stuff, so you won’t get any AMT deduction for the interest paid on the $35,000 part of the new loan.

Deducting Points

Say you were charged one point for the privilege of taking out your new $335,000 mortgage. Each point represents 1% of the new loan balance, so the one point you paid cost $3,350 (1% multiplied by $335,000). (Points are also commonly called loan-origination fees.)

For tax purposes, you must amortize points charged for the home-acquisition debt part of the new loan over the life of the loan. The amortization amount counts as interest that you can write off as an itemized deduction on Schedule A (Line 10). In our example, you can amortize the $3,000 charged for the $300,000 home-acquisition debt part of the new loan (1% multiplied by $300,000) over the 180-month life of the loan. The monthly amortization deduction is $16.67 ($3,000 divided by 180), which amounts to $200 a year. No big deal, but every tax-saving break helps.

What about the $350 worth of points charged for the home-equity debt part of the new loan (1% multiplied by $35,000)? You can also amortize the $350 over 180 months, which amounts to another deduction of $23 a year on Schedule A (once again, use Line 10). However, if you’re an AMT victim, you can only deduct amortized points for up to $100,000 of home-equity debt under the AMT rules to the extent you use the loan proceeds for home improvements. In our example, you used the $35,000 home-equity debt proceeds for other purposes, so you get no AMT deduction for points charged for the $35,000 part of the new loan.

Special Note for Serial Refinancers

If you previously refinanced your mortgage and have been amortizing the points charged for that deal under the rules I just explained, you probably have a good-size unamortized (not-yet-deducted) balance for those points. You can generally deduct that entire unamortized balance when you refinance again. For instance, say the mortgage you refinance in December of this year was taken out in January of 2010. At that time, you paid $3,000 in points for a 30-year loan. You still have $2,800 of unamortized points from the 2010 loan ($3,000, minus $200 of amortization deductions claimed on your 2010 and 2011 returns). On your 2012 Form 1040, don’t forget to deduct the $2,800 of unamortized points (use Line 10 of Schedule A).

Warning: If you refinance with the same lender, the IRS says you must continue amortizing the points from the old loan, but use the life of the new loan to figure your amortization write-off.

The Last Word

The closing statement for your mortgage refinancing deal will probably be littered with charges for things like title insurance, appraisal and document-recording fees, various and sundry other fees, and the amount needed to set up an escrow account with the new lender (if applicable). For a personal-residence loan, none of these charges are deductible (with the possible exception of the premium for mortgage insurance if the tax break for that expense is renewed for 2012). Interest and points should be reported to you (and the IRS) on an annual Form 1098 (Mortgage Interest Statement) sent out by the lender. Property taxes are deductible in the year paid and will show up on monthly statements from the lender if paid from an escrow account.

For more details on deducting principal residence mortgage interest and points, see IRS Publications 530 (Tax Information for Homeowners) and 936 (Home Mortgage Interest Deduction) at .


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