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You Can Refinance Home With One Mortgage and Keep Tax Deduction

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The Washington Post

The Internal Revenue Service has simplified rules on mortgage-interest deductions for homeowners who are refinancing their properties, declaring that those who want to take equity out of their home can refinance with a single mortgage and still retain their deduction.

Congress passed new limits seven months ago on the amount of mortgage interest a homeowner can deduct on federal income tax returns. However, a literal reading of the legislation had led some real estate industry officials to believe that to tap into their equity, homeowners might have to keep their first mortgage and obtain a second mortgage or home equity loan in order to retain their deduction, instead of refinancing with one larger loan.

The revised IRS rules limit the amount of debt that will be eligible for the mortgage-interest deduction, as dictated by Congress. The size of the new mortgage cannot exceed the homeowner’s current outstanding loan balance, plus up to $100,000 in home equity indebtedness for a couple filing a joint tax return or $50,000 for an individual’s return.

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Under the revised guidelines, the total amount a taxpayer can deduct is limited to interest on a $1-million loan for couples filing joint tax returns or interest on a $500,000 loan for an individual return.

As long as they adhere to the loan limits, homeowners can either refinance with one loan or take out a second mortgage in order to deduct mortgage interest on their tax returns. The rules apply retroactively to loans obtained since last Oct. 13. The new loan limits do not apply for loans obtained before last Oct. 13.

In a typical example, if a homeowner has a house valued at $175,000 and an outstanding balance of $20,000 on a first mortgage, he can continue to deduct interest on the remaining $20,000 loan. He can also get a home equity loan up to the $100,000 limit and deduct interest on that loan as well, or refinance the debt into a single $120,000 loan and retain the deduction.

In addition to the amount of interest that may be deducted, the revised rules establish a 90-day rule related to obtaining a mortgage.

If a taxpayer uses cash or some other form of short-term financing that is not secured by the house he is buying and later wants to get a mortgage for the property, he might not be able to deduct the interest on the long-term mortgage if he waits longer than 90 days.

The IRS also has issued additional rules on applying the mortgage-interest deduction to construction or substantial improvement of a house.

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If a taxpayer uses his own savings to build a house or do remodeling and decides to place a mortgage on the home when it is completed, he must get the mortgage within 90 days of completion to get the mortgage-interest deduction. He also is allowed to deduct interest on money spent on improving the house during the 24 months before completion.

If, for example, a person spends $150,000 to buy the land and construct his home in January, 1989, and finishes work on the home in January, 1992, he has until April, 1992, to get a mortgage on the home in order to deduct the interest for money spent from January, 1990, to January, 1992.

The IRS also said that if a husband or wife in the process of a divorce buys out the other spouse’s ownership share of their jointly owned home, the person making the purchase can deduct the interest on a loan obtained to gain full ownership of the house.

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