Refinancing Your Mortgage Still Attractive & Comes With Tax Breaks
In a November 2011 article published here, I wrote about the benefits of refinancing your home mortgage.
With mortgage interest rates continuing at historical lows, refinancing your current mortgage still could be attractive, even if you already refinanced in the not so distant past. You see, mortgage rates have continued their downward spiral, so refinancing could still be a good deal even for those who refinanced within the last couple of years.
For instance, rates on a 30-year fixed mortgage were as high as 5.0% as recently as February 2011, and now those rates incredibly are down around 3.4% (as of this writing).
And refinancing comes with some very nice tax breaks, but there are rules that you need to know about.So, let's dive in!
First of all, let's deal with those nasty closing costs that invariably come with the loan.It would be nice if those costs would be deductible, wouldn't it?Unfortunately, most are not.
However, all is not lost.Most people will pay what are called "points", or loan origination fees as they are sometimes known, for obtaining the loan.
Points are expressed as a percentage of the loan amount, and some, possibly even all, such points are deductible as an itemized deduction over time by amortizing them ratably over the life of the loan.
The points that may be amortized is determined by the amount of the loan itself.Basically, points paid on the amount of refinanced "acquisition indebtedness" (which I will discuss later) are deductible, as are points paid on up to $100,000 of loan proceeds in excess of the refinanced acquisition indebtedness.Any points paid on loan amounts exceeding this are not deductible.
Here's a tip: if you have previously refinanced your loan and have not fully amortized the points paid, you can deduct the full unamortized balance when you refinance again.That is, unless you refinance with the same mortgage company, in which case you must continue to amortize the old balance and do so over the life of the new loan.
Mortgage insurance premiums paid have been also deductible the past few years, but that expired at the end of 2011.Watch for a possible extension of this deduction by Congress to 2012 and thereafter.
The main tax benefit associated with home mortgages is the deduction for mortgage interest expense.
Most people are aware that mortgage interest is an itemized deduction that can be taken on your tax return on original mortgages incurred to acquire a home, up to $1 million of debt (interest on debt over $1 million is generally not deductible).
The allowable deduction can get a bit tricky when you refinance a mortgage and you borrow more than the unpaid balance on the loan being refinanced.This is where the idea of acquisition indebtedness that I mentioned earlier comes in.
Acquisition indebtedness in general is the original mortgage that was taken out to acquire the home.
The interest on a refinanced loan is fully deductible to the extent it is being paid on the remaining acquisition indebtedness being refinanced (subject to the $1 million rule mentioned above); in other words, the original amount borrowed minus any principal already paid.
In addition, the interest can be deducted as home equity mortgage interest on up to $100,000 of loan proceeds borrowed over and above the remaining acquisition indebtedness.But, the interest on any home equity debt exceeding $100,000 is not deductible.Confused yet?
Let's look at an example.
Say you have a mortgage of $200,000 (all original acquisition indebtedness) that you want to refinance. The home is worth $350,000, so you have some equity that would allow you to borrow more.You decide to borrow an extra $50,000. You use the extra $50,000 from the new loan to pay off some credit cards and buy a boat.
In this situation, your new mortgage is considered to have two distinct parts for tax deduction purposes.
The first part has an initial balance of $200,000, which equals the refinanced acquisition indebtedness balance from your old loan.All the interest on this part is deductible as an itemized deduction since the balance doesn't exceed $1 million.
The second part, equaling the cash you took out (the home equity debt), has an initial balance of $50,000.The interest on this part is also deductible regardless of how you used the money since it is less than the $100,000 limit on home equity debt.
If you had borrowed more than $100,000 extra, the interest on the extra debt would generally be nondeductible.
A word of warning here:
A few weeks back (The Sun-Times 10/19/12 edition) I wrote about the alternative minimum tax (AMT) and how it could affect up to 1/5 of Americans.If you are subject to AMT, you will only be able to deduct interest on the home equity debt for AMT purposes to the extent you use the loan proceeds to pay for home improvements.
In our example above, because the home equity debt was used for other things, no deduction for AMT purpose is allowed for the interest paid on the $50,000 part of the new loan. The same is true for any points paid on the $50,000 part of the new loan.
The main thing is this. While you don't want to refinance unless it makes economic sense to do so, be sure you are aware and take full advantage of every break you have coming to you if you do.
