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With interest rates hitting 40-year lows recently, mortgage refinancing is more popular than ever. For most people, the tax consequences of refinancing are straightforward; you get to deduct the interest you pay on the new loan, just as you did with the loan which was refinanced. However, if you pay points, or if the new loan is larger than the refinanced loan, there are some tax rules that you should be aware of.
Points Paid
Points (also called prepaid interest or loan origination fees) are deductible in full only if the loan to which they apply is for the original purchase of a personal residence. Since refinancing is not the original purchase, points paid with refinancing a loan cannot be deducted all at once.
Instead, they are required to be amortized, which means they are deducted in part each year over the life of the loan. To calculate the deductible amount, just divide the points you pay by the term of the refinanced loan. For example, if you pay $3,000 in points and your refinanced loan is for 30 years, you can deduct $100 in points each year.
If you are already amortizing points from a previous refinancing, you can deduct the full remaining balance of those points when you refinance with a new loan.
When a Refinanced Loan is Greater than the Previous Loan
With most home values rising every year, it is tempting to take money out of your house when you refinance. When you refinance for an amount that is larger than the principal amount of mortgage debt that is due immediately before refinancing, the extra amount is called a home equity loan. Interest on home equity loans is still deductible, subject to certain limits:
- Interest associated with only the first $100,000 of the combined balances of home equity loans is deductible. Interest on any debt over this limit is considered nondeductible personal interest.
- Interest on any mortgage debt over $1 million is not deductible.
- The preceding amounts are reduced by 50% for married individuals filing separate returns.
- Interest on the amount of debt greater than the home’s fair market value is not deductible.
- The interest associated with home equity debt is a preference item for Alternative Minimum Tax (AMT) purposes unless the home equity loan is used to improve their home.
This means that such interest is not deductible for AMT. If you are already paying AMT or are close to it, you may not get the full tax benefit from the home equity loan interest you pay.
Example
Bruce and Jane purchased their home for $100,000 in 1984, and it is now worth $250,000. This year they decide to refinance their original mortgage, which had $60,000 of principal remaining, into a new $200,000 loan. After the refinancing, Bruce and Jane are only allowed to deduct interest associated with $160,000 of the loan balance: $60,000 of purchase debt remaining from the original loan, and the maximum $100,000 of home equity indebtedness. The interest they pay on the remaining $40,000 ($200,000 - $160,000) of mortgage debt is non-deductible personal interest.
Additionally, the interest they pay on the $100,000 home equity loan is not deductible for AMT purposes.
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