Are you considering refinancing your home mortgage? Are you aware that a refinance may impact your taxes? The choices you make in refinancing your mortgage could affect your taxes for years to come. This is what you need to know.
1.) Track “Points”
Points are essentially prepaid interest, paid in return for a lower interest rate. While you can fully deduct the points you pay when you buy your home, points paid on a refinance are generally amortized over the term of the loan. That means if you refinance into a thirty year loan, your points must be deducted over thirty years. If you pay $5,000 in points to obtain a new thirty year loan, you would deduct $167 per year over the next thirty years ($5,000 divided by 30 years).
2.) Write-off Old Points
If you are still writing off points on a refinance when you refinance again, the balance of points from the old loan becomes immediately deductible. This is also the case when you sell your home. In the example above, the $5,000 points were being deducted at the rate of $167 per year. When that loan is paid off, either through another refinance or through selling the home, the balance of points that had not been deducted previously is then deductible.
3.) Track Cash Out
Not all mortgage interest is deductible. Tax rules separate your home mortgage into two categories, home acquisition and home equity. Home acquisition debt is the amount of the mortgage taken out during the original purchase of the property. When you refinance, any monies taken out above the amount of that original mortgage loan is considered home equity interest.
Overall, you can deduct interest on mortgage debt of up to $1.1 million total. However, only $100,000 of that mortgage debt can be home equity debt. This means that you can increase your mortgage up to $100,000 over the original purchase debt and the interest is still deductible, as long as your total mortgage loans are still under that $1.1 million mark.
4.) Trace Funds
If you take mortgage debt over the limits mentioned above, the interest may still be deductible depending on how the funds are used. When you use those funds to expand your business, the interest may be deductible business interest. If you buy investments, the interest may be investment interest expense.
Equity debt that is used for home improvements may be considered home acquisition debt and so would not be limited by the $100,000 threshold, but would still be subject to the $1.1 million overall cap.
5.) Know Loan Type
For interest to be considered mortgage interest, the loan must be secured by your home. If you pay off your mortgage by using a personal loan secured against different investments, that new loan is not considered a mortgage loan. If you use a personal credit line to make improvements to your home, that is not considered mortgage debt. The loan must be a mortgage loan to be considered mortgage interest.
6.) Check Withholdings
Double-check your tax withholding or estimated tax payments when you refinance. Why? Reducing the interest rate on your loan means the mortgage interest deduction on your income tax returns also goes down. Adjusting your withholding or estimated payments can help avoid an unanticipated tax bill.
7.) Look at the Whole Picture
Not all loan fees are deductible. However, some of the fees paid during a refinance could be added to the basis of your home, which will come in handy when you sell. For this reason, be sure to keep the closing escrow statements for every refinance and make sure your tax professional has a copy.
Keep in mind that the rules detailed above are rules for your personal residence (first and second homes). The rules for rental properties or investment properties are different. Ask your tax professional if you need more information on refinancing or mortgage interest tax deductions.