Gauge the tax impact of refinancing
With mortgage rates still relatively low across most of the country, many homeowners are continuing to refinance their mortgages. If you’re planning to join their ranks, you’ll want to first look closely at the tax impact of such a move. Here are some tips to help you avoid having a tax bite cancel out the potential benefit of refinancing.
Can you deduct it?
The mortgage interest deduction is available for interest on loans secured by your principal home or a second home. What’s considered a “home”? You might be surprised at what qualifies. For example, U.S. tax law considers a mobile home, trailer or boat to be a home so long as it has sleeping, cooking and toilet facilities.
The tax code allows you to deduct interest on up to $1 million in “acquisition indebtedness” — debt that’s used to buy, build or substantially renovate a home — plus interest on up to $100,000 in home equity debt that’s used for any purpose. If you’re subject to the alternative minimum tax (AMT), however, the rules are more restrictive. So be sure to consult your tax advisor.
The limits apply to the combined principal of all loans secured by your principal and second homes. If your tax status is married filing separately, the limits are cut in half to $500,000 and $50,000, respectively.
The IRS has clarified that homeowners who have more than $1 million in acquisition indebtedness may deduct interest on the excess as home equity debt (subject to the $100,000 limit).
Take a loan or cash out?
When you refinance your mortgage, the tax treatment of interest on the new loan will depend on whether you do a straight replacement loan or a cash-out refinancing. With a replacement loan, you borrow an amount equal to the outstanding balance on the old mortgage. Interest on the new mortgage is fully deductible, so long as your total acquisition indebtedness is no more than $1 million.
With cash-out refinancing, in which you borrow more than you need to cover your outstanding mortgage balance, the tax treatment depends on how you use the excess cash. If you use it for home improvements, for example, it’s considered acquisition indebtedness, and the interest is deductible (subject to the $1 million limit). If you use it for another purpose, such as buying a car or paying your child’s college tuition, it’s considered home equity debt subject to the $100,000 limit.
What about points?
When you buy a home, prepaid interest is deductible immediately. When you refinance, these “points” are amortized and deducted ratably over the life of the loan. Let’s say you refinance a $400,000 mortgage with a new, 15-year loan, paying two points ($8,000). Even though you pay the points up front, you must deduct them over 15 years at a monthly rate of $44.44 [$8,000 / (15 years × 12 months)]. Thus, while the deduction for a full year ($8,000 / 15 years) will be about $533, there will be a smaller deduction in the first and the last year.
On the other hand, if you’re already amortizing points — from a previous refinancing, for example — and you refinance with a new lender, you can deduct the unamortized balance in the year you refinance. But if you refinance with the same lender, you must add the unamortized points from the old loan to any points you pay on the new loan and then deduct the total over the life of the new loan.
There’s an exception for certain cash-out refinancings. You can immediately deduct points attributable to the portion of the new loan that’s used to improve your principal residence. In the previous example, if you use $100,000 of the $400,000 loan for home improvements, you can deduct one-quarter of the points, or $2,000, up front.
Whom to call?
After initially buying your home, refinancing it is one of life’s biggest financial maneuvers. Be sure to discuss your strategy with your tax advisor in advance.
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