Tax Aspects of Refinancing a Home Mortgage

Jeffrey Arnol, KOS Managing Partner

When thinking about refinancing your home mortgage, it is important to understand the tax rules regarding the deductibility of the interest you will pay, the points you may pay and other fees incurred in connection with the refinancing.

Interest that you pay on a home mortgage is deductible within limits depending on which category the debt falls into, including interest on the refinanced mortgage.

  • Home acquisition debt is a mortgage you took out after Oct. 13, 1987, to buy, build, or substantially improve your main or second home, and that is secured by that home. Interest on home acquisition debt is deductible, but only $1 million ($500,000 if married filing separately) of home acquisition indebtedness is taken into account in calculating your interest deduction.
  • Home equity debt is any debt secured by your first or second home, other than home acquisition debt, or grandfathered debt. Thus, it includes mortgage loans taken out for reasons other than to buy, build, or substantially improve your home, and mortgage debt in excess of the home acquisition debt limit. Interest is deductible on up to $100,000 of home equity debt ($50,000 if married filing separately).
  • Grandfathered debt is mortgage debt secured by your first or second home that was taken out before Oct. 14, 1987, no matter how you used the proceeds. All of the interest you pay on grandfathered debt is fully deductible.

If the old mortgage that you’re refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, up to the principal balance of the old mortgage just before it was refinanced. The interest on this portion of the new mortgage will be deductible. Any debt in excess of this limit won’t be home acquisition debt, but it may qualify as home equity debt, subject to the $100,000/$50,000 limit.

If you’re refinancing grandfathered debt for an amount that isn’t more than the remaining debt principal, the refinanced debt will still be grandfathered debt. If the new debt exceeds the mortgage principal on the old debt, the excess will be treated as home acquisition or home equity debt.

Grandfathered debt that was refinanced is treated as grandfathered debt only for the period that remained on the old debt that was refinanced. Once that period ends, you must treat the debt as home acquisition debt or home equity debt, based on how the debt proceeds are used.

This means that if you refinance your mortgage and the refinanced loan balance increases by more than $100,000, the interest paid on the excess generally isn’t treated as mortgage interest and may not be deductible, depending on how you used the proceeds.

In general, points that you pay to refinance your home aren’t fully deductible in the year that you paid them. Instead, you can deduct a portion of the points each year over the life of the loan.

To figure your deduction for points, divide the total points by the number of payments to be made over the life of the loan. Then, multiply this result by the number of payments you made in the tax year.

However, you may be entitled to a larger first-year deduction for points if you used part of the proceeds of the refinancing to improve your home and you meet certain other requirements. In that case, the points associated with the home improvements may be fully deductible in the year they were paid.

For example, say that you refinance a high-rate mortgage that has an outstanding balance of $240,000 with a new lower-rate loan for $300,000. You use the proceeds of the new mortgage loan to pay off the old loan and to pay for $60,000 of improvements to your home. Since 20% of the new loan was incurred to pay for improvements, 20% of the points you paid can be deducted in the year of the refinancing.

If you’re refinancing your mortgage for the second time, the portion of the points on the first refinanced mortgage that you haven’t yet deducted may be deductible at the time of the second refinancing.

A prepayment penalty that you pay to terminate your old mortgage is deductible as interest in the year of payment but fees paid to obtain the new mortgage aren’t deductible, nor can you add them to your basis in your home to reduce the gain when you sell it. Examples of such nondeductible fees are credit report fees, loan origination fees, and appraisal fees.

Beginning in 2016, Form 1098 which is issued to indicate the amount of home mortgage interest paid has additional information. Lenders must now report the amount of principal outstanding at the start of the year, the mortgage origination date and the address of the property securing the loan. The idea is to help the IRS better monitor the mortgage interest deduction rules, especially for cash-out financings which is an area considered ripe for potential noncompliance.

Although seemingly straightforward, these rules can be complex and lead to additional IRS scrutiny so please contact your KOS Advisor if you have any questions.