No matter what the reason for refinancing, hidden potential tax breaks abound when you refinance your home. If you are considering refinancing, understand the potential tax savings as well as the limitations on certain tax deductions, such as mortgage interest and points paid, before you decide how you want to structure your refinance.
Deducting Undeducted Points
Typically, when you take out a first mortgage, you elect to deduct all points paid in the year you take out the mortgage. However, some taxpayer elect to amortize the points over the life of the mortgage. If you have undeducted points from the mortgage that you are refinancing, you can deduct the remaining amount in the year you refinance. For example, if elected to amortize your points and had deducted $2,000 of the $5,000 you paid, you could take a $3,000 deduction in the year you refinance.
Deducting New Points
Points paid on the refinance cannot be deducted immediately. Instead, you must amortize them over the life of the loan and take a deduction for the amount paid for the given tax year. For example, if you have a 240-month refinance and you pay $6,240 in points, you can deduct $26 per month. If you refinance again before you are able to deduct all of the points, you can deduct any remaining points in the year of the refinance.
Limits on Deducting Interest
When you refinance, only the amount of the refinance equal to the principal remaining on your mortgage is considered to be mortgage debt. For example, if you owe $400,000 and you do a cash-out refinance in which you borrow $550,000, only the first $400,000 is considered mortgage debt. Additionally, only the interest on the first $1 million of mortgage debt is deductible. If you are married filing separately, each spouse can deduct the interest on up to $500,000.
Home Equity Debt Deduction
If you refinance for more than you previously owed, the additional amount can qualify for a home equity interest deduction. However, the limits are significantly smaller than for home mortgage debt: only the interest on the first $100,000 ($50,000 if married filing separately) can be deducted. For example, if you refinance for $150,000 more than you owed on your original mortgage, you are limited to deducting only the interest on $100,000 of the additional debt.
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