You may be considering a mortgage refinance for several reasons: to lower your interest rate, to cash out some of your equity to pay high-interest bills or education costs or to simply lower your mortgage payment. These may all be good reasons to refinance; however, a refinance has several consequences, and one of them is a limitation of how much of your mortgage interest you can deduct from your tax return. Before refinancing your loan, be sure to explore the tax consequences if you do so.
Tax Laws and Refinancing
The tax laws regarding refinanced mortgages can be complicated and tricky to the layperson, so a good basic understanding is essential. Remember that the treatment of mortgage refinancing by the tax laws hinges on how the money is used which you receive from the refinance.
If you borrow more money than the balance on your mortgage, the excess is treated differently than the original principal amount. Perhaps you owe $225,000 on a house which is worth $425,000. You choose to borrow $400,000 and use the extra $175,000 to pay off bills or pay for college. This means that the mortgage interest on only $225,000 of your mortgage is deductible, while $175,000 is considered a “home equity” type of loan. Interest on this money is taxed differently than your original mortgage interest.
On the other hand, you might use that extra $175,000 to make improvements to your home, or to put a down payment on a second home or vacation property. If you do this, the entire amount of interest may be deductible, as the IRS views this as using the mortgage to buy a residence. The residence in question, however, must be one in which you live at least part of the time; rental properties fall under investments, and do not count toward your mortgage interest deduction.
The Home Equity Loan rule
You may, however, be able to sidestep this rule under the “home equity loan” rule. This allows you to deduct all of your primary home’s mortgage interest as long as the excess over the principal or acquisition cost does not total more than $100,000. The limit on acquisition, or original principal, is $1,000,000. What this means is that you can borrow up to $1,000,000 to acquire or refinance an existing principal loan on your home, and up to $100,000 in equity to pay off bills or use for other purposes.
Using the above example, the homeowner would be able to deduct the interest on $325,000 of the mortgage–$225,000 principal balance plus $100,000 in home equity. The interest on the other $75,000, however, would not be tax deductible.
In addition, this interest problem is inherited in each loan you make on the home. You cannot run up the principal balance with a home equity loan, then turn around and refinance as if the principal was all acquisition—even though at that point you would have to pay that amount to “acquire” the home. There are exceptions in some states for divorce or other property dissolution problems, but in general, once you refinance, you have lost the interest deductions over $100,000 plus the acquisition cost for the rest of the time you own the home.
Alternative Minimum Tax
If you are subject to Alternative Minimum Tax, or AMT, there is another restriction which can apply. If you are subject to AMT, you may not be able to deduct home equity loans at any level. This depends on the type of loan and the purpose for which it is used. Generally, in the case of home equity loans, no deductions can be made unless the proceeds are used directly to upgrade or repair your home—the IRS has a definition for “substantially improved” which must be met in order to take this deduction.
This is all very confusing to the average person. Your best bet is to talk to your attorney or accountant prior to refinancing to see what kind of impact your refinance will have on your tax deduction situation. Generally speaking, the more you owe on your home, the less impact the tax deduction rules will have on you. If you owe very little on your property, your accountant or attorney may advise you not to refinance, as all of the interest you pay may not be tax deductible. It is sometimes possible to “sell” your home to a member of your family, although the IRS has strict rules about what constitutes a sale, as well. Be sure to discuss any plans you have with your accountant and a tax attorney, especially if you are unsure about what the tax consequences may be.
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