Tax Insights

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Tax consequences to refinancing your home

Mortgage interest rates have decreased this year and a lot of people have jumped at the opportunity to refinance their home mortgage loans to take advantage of these lower rates. So, what does this mean for your tax situation?

As you may already know, the IRS allows you to deduct your home mortgage interest on the first $750,000 ($350,000 if married filing separately) if the loan originated after December 15, 2017. Any debt incurred before that date has limits of $1 million and $500,000 for married filing separately. This can be your main home and/or your second home. If you refinance debt that was incurred before December 16, 2017, you will remain “grandfathered” on this debt to the extent the initial principal balance of the new loan does not exceed the principal balance of the old loan at the time of the refinancing.

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Another option that is appealing when you refinance is doing a “cash-out refi”. This is a great option for those that want to put the equity back into your pocket and use it for other debt such as credit cards, home renovations, car purchases, etc. This may cause an issue for your tax deduction. For tax purposes, you can only deduct the mortgage interest on the debt that was used to buy, build, or substantially improve your home. Let’s say you are married and have a current principal balance owed of $500,000. You complete a cash-out refinance for $550,000 and take that $50,000 to renovate your kitchen. In this case, you would still be allowed to deduct the full amount of interest. However, if you took that $50,000 to buy a new car and pay off credit card debt, the interest on that $50,000 would not be deductible.

Points that you pay during the refinance are also deductible. However, generally you are required to deduct over the life of the loan (generally 15 or 30 years) or you could potentially be able to deduct them in the year paid. Per the IRS’ Publication 936, you must meet all of the following tests for the points to be deductible in the year paid regarding a refinance:

  1. Your loan is secured by your main home
  2. Paying points is an established business practice in the area where the loan was made
  3. The points paid were not more than the points generally charged in that area
  4. You use the cash method of accounting (report income in the year you receive it and deduct expenses in the year you pay them, most taxpayers report this way)
  5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes
  6. The funds you provided at or before closing were at least as much as the points charged.
  7. You use part of the refinanced mortgage proceeds to substantially improve your home

Keep in mind that you must itemize your deductions (versus taking the standard deduction) to take advantage of the mortgage interest deduction. For many taxpayers, having a mortgage interest deduction is what allows them to push them over the standard deduction amount ($12,400 for single and married filing separately, $24,800 for married filing jointly and $18,650 for head of household for tax year 2020). After refinancing, this may no longer be the case as your interest paid for the year will likely decrease. Consult your tax advisor today to see if/how refinancing will affect your tax situation.

Kelsey L. Phillips, CPA