If you are one of the many homeowners who has taken advantage of, or is about to take advantage of 50-year low interest rates to refinance your home mortgage, then you should make sure to claim all of the very lucrative tax benefits that you may not even know you gained by refinancing. When added to the main advantages of locking in a historically low mortgage interest rate and possibly cashing out with a home equity loan, the tax advantages of refinancing your mortgage present prudent financial gains that will help set you on the path to wise financial planning for the future and well into retirement.
Mortgage Interest Deductions
Of course, interest deductions have comprised one of the main selling points of home mortgages; however, when refinancing or taking out a second mortgage or home equity loan, the IRS allowable mortgage interest tax deductions can prove more difficult to assess, but still very advantageous.
For example, homeowner Smith holds a first mortgage worth $400,000 but decides to take advantage of the historically low mortgage interest rates to refinance that first mortgage with a new 30-year mortgage for $600,000, paying, in the process, 1.5 points, or $6,500 (each point equals 1 percent of the total loan amount). Homeowner Smith then uses the additional $200,000 from the new mortgage to extinguish several high-interest credit-card bills, revolving loans, car loans and other expenses.
For illustrative purposes, let’s assume that Homeowner Smith’s house is worth at least $600,000 at the time that he or she refinanced. Now, as far as the IRS classifies mortgage debt, Homeowner Smith actually holds two new mortgages! The IRS treats the first $400,000 of Homeowner Smith’s new mortgage loan (the balance on the old mortgage that was paid off as a result of the refinancing) as “home-acquisition debt.” As such, according to the IRS, the interest on this “home-acquisition debt” qualifies as an itemized deduction on line 10 of Homeowner Smith’s Schedule A.
Keep in mind, however, that if Homeowner Smith’s (or any homeowner’s) adjusted gross income during the year of the home mortgage refinancing totaled more than $159,950 (or $79,975 if married but filing separately) the above-mentioned deduction falls under the jurisdiction of the phase-out rules for itemized deductions).
As for the remaining $200,000 of Homeowners Smith’s new mortgage, the IRS treats it as a home-equity loan. The interest on this portion of the new mortgage also qualifies as an itemized deduction, meaning that Homeowner Smith can list it also on line 10 of his or her Schedule A.
Keep in mind, however, that the IRS only allows interest deductions on home-equity loans up to $100,000. So, that means if you hold home equity debt of, for example, $300,000, you can itemize and deduct the interest on the first $100,000, but you cannot deduct the interest paid on the principal above that amount. So, for Homeowner Smith in the example above, he or she can deduct the interest on half of the home equity portion of the new mortgage. All-in-all, Homeowner Smith took a $600,000 home mortgage financing, locked-in all-time low rates, used the equity cash-out to pay down higher interest debt (always wise financial planning) and earned a tax deduction for the interest on $500,000 of the debt.
Fair Market Value and Excess Debt
Many homeowners do not realize that the tax code contains strict and specific provisions that govern itemized deductions from home mortgage refinancing. A little known but very important provision governs debt in excess of fair market value. For example, if your home is worth $120,000 and you refinance your home mortgage for $150,000, you cannot itemize and deduct the interest on the entire home loan. You can certainly deduct the entire amount of interest on the $120,000 portion of the mortgage that applied to the “home acquisition”; however, you can only deduct the mortgage interest expense on two thirds of the home equity portion. The IRS considers interest on the remaining portion of the home equity loan to be a personal expense. Several exceptions to this rule exist. For example, using the cash-out from the home equity loan to fund your own small business re-entitles you to itemize and to deduct the interest expense.
The Point of Those Mortgage Points
Home buyers seeking to save money in long term interest costs often pay higher up-front points at closing. A point, an interest charge paid at the closing of a home mortgage or home mortgage refinancing, equals 1 percent of the total loan amount. Paying even a small amount more in those up-front closing points can save a homeowner a significant amount in interest expense over the life of a home mortgage. Those savings alone justify the higher up-front outlay; however, the IRS adds further incentive by allowing home buyers to itemize and deduct those points. Thus, homeowners who pay more in points up front at the closing of a home loan get rewarded with a lower mortgage and an IRS tax write-off!
Keep in mind, however, that the IRS draws a distinction between points paid on a traditional home mortgage (used to purchase a home) and on a mortgage refinancing. When purchasing a property, each point is fully deductable in that same tax year as the purchase. For example, a homeowner who pays one point of origination fee on a $500,000 mortgage will pay $5,000, but will get that money back in the form of tax deduction. When refinancing, however, homeowners must amortize the deduction from their points over the life of the mortgage. For example, a home buyer who pays 3 points on a new $400,000 loan will gain a $12,000 deduction that year. If that same owner refinances $400,000 and pays 3 points, he or she will still gain $12,000 in tax deductions, but will need to amortize that $12,000 over the life of the mortgage. For instance, if the homeowner took a 30 year mortgage, then that homeowner would receive $400 dollars per year in tax deductions.
Homeowners who refinance again or sell their homes can claim the entire unamortized deduction remaining from the points that they had paid up front. For example, a homeowner who refinances in 2010 and pays $3,000 in points on a 30 year home mortgage refinance will gain $100 in tax deductions each year for the thirty year term of his or her mortgage. If that same homeowner decides to refinance again in 2013, he or she can claim the entire balance of the remaining unamortized portion from the 2010 refinancing in the year of the new refinancing, in this case, 2013. For this homeowner, that balance would total $2,600. Homeowners can itemize this write-off on line 10 or 12 of Schedule A in their tax return.
The limits and schedules mentioned above for interest deductions also apply to deductions from up front points. Homeowners who pay up front points related to home-equity debt are allowed, under IRS tax and mortgage interest deduction guidelines, to amortize those points in the same proportion as the interest. Of course, the IRS’s $100,000 or less rule from above still applies. The rule about fair market value of the home also still applies. Remember that the house cannot be valued less than the home-equity debt plus the acquisition debt. These up front point amortization tax write-offs for your home-mortgage can be claimed on lines 10 or 12 of Schedule A.