Refinancing Your Mortgage

With interest rates still very low, many homeowners have taken this opportunity to refinance their mortgages and obtain a lower interest rate. From a tax perspective, there are consequences to refinancing.

Applicable mortgage limits

Generally, you may deduct interest on a mortgage on a primary residence and second home (one you designate if as such) up to set limits, where the debt is secured by the residence and used to buy, build, or substantially improve that home. The limit on home acquisition debt generally depends on when you took out the mortgage:

• For debt secured after October 13, 1987, and prior to December 16, 2017, the limit is $1 million ($500,000 if married filing separately).
• For debt secured after December 15, 2017, the limit is $750,000 ($375,000 if married filing separately).

If your mortgage fell under the pre-December 16, 2017, limit and you refinance now, does that limit or the newer limit apply? The new mortgage will qualify for the $1 million  home acquisition debt limit only up to the amount of the balance of the old mortgage principal just before the refinancing. For example, if you have $853,800 outstanding on a mortgage you obtained on March 1, 2015, and you refinance so that your new mortgage amount is the same $853,800, the $1 million debt limit continues to apply and all of the interest on the new loan is deductible.

If the new mortgage exceeds the refinanced balance, any additional debt not used to buy, build, or substantially improve a qualified home isn’t home acquisition debt and the interest on this portion of the debt isn’t deductible. If the additional debt is used to buy, build, or substantially improve a qualified home, it is treated as home acquisition debt and the interest on this portion of the loan is deductible if it falls within the newer $750,000 limit. However, the $750,000 limit is reduced by any refinanced pre-December 16, 2017 amount. For example, if you have $853,800 outstanding on a mortgage you obtained on March 1, 2015, and you refinance so that your new mortgage amount is $1 million, and you use $146,200 to pay off other debts, you may treat only $853,800 as acquisition indebtedness and deduct interest on this portion of the loan. Even if you use the $146,200 to substantially improve the home, so that the $146,200 qualifies as home acquisition debt, none of the interest on this portion is deductible because the debt is subject to the $750,000 limit, which is reduced to zero by the $853,800 of acquisition indebtedness. However, if the refinanced pre-December 16, 2017 amount was $600,000 rather than $853,800, the total acquisition debt including the extra $146,200 would be below the $750,000 limit, and then all of the interest on both portions of the debt would be fully deductible.

Points

When you refinance your mortgage, you may have to paid points to obtain the loan. A point represents one percent of the mortgage, so a point on a $200,000 mortgage is $2,000. Generally, points you pay to refinance a mortgage aren’t deductible in full in the year you pay them. This is true even though the new mortgage is secured by your main home. So, if you refinance your outstanding loan balance and use the proceeds of the new loan to pay off this amount, points on this refinancing have to be deducted ratably over the term of the new loan.

However, if you use part of the refinanced mortgage proceeds to substantially improve your principal residence and you would have qualified to deduct the points in full if this had been an initial mortgage, you may fully deduct the part of the points related to the improvement in the year you paid them with your own funds. The balance of the points must be deducted ratably over the term of the loan, so, for the year of payment, you may deduct the points related to the improvement along with the balance of points allocable (depending on number of loan payments) to that year. This potential write-off does not apply to refinancing a mortgage on a second home (i.e., one that is not your main home).

What about the points you already incurred but have not yet fully deducted? This may occur if you previously refinanced your mortgage and were amortizing the points over the term of the new loan. You may deduct in full in the year of refinancing any remaining balance of previously incurred points that have not yet been deducted.

Conclusion

Refinancing may produce a lower monthly cost for home ownership and save you thousands of dollars over the term of the loan. However, don’t ignore the tax results that refinancing may trigger.