When interest rates drop, millions of households, just like you, flock to lenders to refinance their mortgages. Before jumping into mortgage refinancing, it's smart to familiarize yourself with tricky tax rules on what is or is not deductible for interest payments. Here are some reminders on how the rules work for mortgage refinancing:
Mortgage Refinancing Rules for Tax Deductions
Whether borrowers are entitled to deduct interest on the excess amount depends upon how they use the proceeds from the mortgage refinancing and the amount of the proceeds. When borrowers use the amount in excess of the existing mortgage to buy, build or substantially improve principal residences, meaning year-round dwellings, or second homes such as vacation retreats, their interest payments come under the rules for home acquisition loans. Those rules allow them to deduct the entire interest as long as the excess plus all other home acquisition loans do not exceed $1,000,000, dropping to $500,000 for married couples filing separate returns.
When borrowers use the excess for any other purposes, another set of rules prohibits deductions for payments of interest on "consumer loans." This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts such as overdue federal and state income taxes. There is, though, a limited exception for interest on student loans, one of those "above-the-line" subtractions to arrive at adjusted gross income, the amount on the last line of the first page of the 1040 form.
Exceptions to Rules for Mortgage Refinancing Tax Deductions
But most borrowers are able to sidestep these restrictions on deductions for consumer interest, thanks to the rules for home equity loans. Those rules allow them to deduct the entire interest as long as the amount in excess of the existing mortgage plus all other home equity loans do not exceed $100,000, dropping to $50,000 for married couples filing separate returns. It makes no difference how borrowers use the proceeds.
When their refinanced loans are partly home acquisition loans and partly home equity loans, there is an overall limit of $1,100,000 �€” $1,000,000 home acquisition debt and $100,000 home equity debt, dropping to $550,000 for married couples filing separately.
When the loans exceed the ceiling of $1,000,000 for home acquisition loans and $100,000 for home equity loans, the excess generally is categorized as nondeductible personal interest. The general disallowance is subject to exceptions for loan proceeds used for business or investment purposes.
Mortgage Refinancing Tax Deductions for Taxpayers Subject to AMT
Yet another restriction applies to the steadily growing number of borrowers burdened by the AMT (alternative minimum tax). The AMT allows deductions for interest payments on home acquisition loans of up to $1,000,000. But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless the loan proceeds are used to buy, build, or substantially improve the dwellings �€” one reason why advertisements for home equity loans frequently finesse the troublesome question of tax deductibility.
Julian Block is a tax attorney in Larchmont, NY.
At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.