With home
mortgage rates at the lowest level in years, you
may be considering refinancing your adjustable-rate or higher-interest
fixed-rate mortgage to lock in what looks like a real bargain. Although taxes
take a back seat to the basic issue of whether refinancing saves enough money
to be worthwhile, you should be aware of the basic tax rules that come into
play.
The most widely applicable rules are as follows:
Interest on the New Loan
The interest you pay on the new loan will be completely
deductible if: 1) the new loan amount does not exceed the balance remaining on
your old mortgage; 2) when you obtained the mortgage you are replacing,
you used the loan proceeds to buy or substantially improve your home; and, 3)
the new loan balance does not exceed $1 million.
Interest you pay on borrowed funds in excess of the amount
necessary to retire the old mortgage also will be completely deductible to the
extent that the new money is used to substantially improve your home.
To the extent they are not used for substantial
improvements, borrowed funds in excess of the amount necessary to retire the
old mortgage will be deductible as "Home-Equity Debt". Generally,
the interest paid on up to $100,000 of that debt is deductible as home
mortgage interest regardless of how the proceeds are used.
What these rules boil down to is that the interest you pay
on the new loan usually will be deductible if: 1) you are refinancing your old
mortgage dollar-for-dollar; 2) your new loan amount exceeds the old mortgage’s
remaining balance and you use the new money for substantial improvements to
your home; or, 3) the new loan money is not used for home improvements, but
does not exceed $100,000.
Points on the New Loan
Points paid in connection with buying or substantially
improving your main home are currently deductible. However, if you must pay
points on a refinance loan, this charge will be currently deductible only if
you pay the charge out of your own cash at the closing (that is, the charge is
not withheld from the mortgage loan); and, only to the extent that the new
loan proceeds are used to substantially improve your home. So if you refinance
your existing home mortgage and use none of the new loan for substantial
improvements to your home, any points you pay on the transaction will not be
currently deductible. Instead, you’ll have to deduct the points over the
life of the new mortgage.
For example, suppose you refinanced your home mortgage
several years ago and used the proceeds to pay off in full your original home
mortgage. Your refinancing mortgage (Loan #2) was a 30-year fixed rate loan
for $100,000. You paid three points ($3,000) on the refinancing. Because all
of the loan proceeds were used to pay off the original mortgage and none were
used to buy or substantially improve your home, all of the points on the
refinancing loan had to be deducted over the loan term. This year, you
refinance again with a lower-interest mortgage (Loan #3) when there is a
remaining (not yet deducted) points balance of $2,400 on Loan #2. You can
deduct this $2,400 as home mortgage interest on your 2005 return.
As you can see, refinancing a home mortgage is anything but
simple. There may be additional complications if there are several mortgages
on your home, or if you own a vacation home as well as a main home.
Should you have any questions or would like to discuss this
further, please do not hesitate to contact us.
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