What’s Deductible After Refinancing Homes

Mary Alvarez is confused. The Anaheim resident knows that she saved a bundle when she refinanced her home mortgage, as well as the mortgage on her Montana vacation home. But now that she’s contemplating filing her annual tax return, she’s having a doozy of a time trying to figure her taxes.

And Alvarez isn’t alone. Many homeowners refinanced their mortgages in 1992 to take advantage of rapidly declining interest rates, but refinancing raises a myriad of tax questions about what is and isn’t deductible.

The answers are seldom simple. Sometimes, they depend on who you are, how much you earn, what kind of property it is and whether or not you got cash out of the deal.

Here’s a question-and-answer look at refinancing and taxes:

Q: Are the fees, points and interest that I paid when refinancing my home mortgage tax deductible?

A: Assuming your home loan is for $1.1 million or less, all of the interest charges are tax deductible. None of the fees--such as appraisal, escrow and loan origination charges--are deductible. But part of the points (the one-time, up-front charge you pay to secure the loan) are.

Q: How much of the points can be deducted?

A: Under normal circumstances, points--which are considered prepaid interest--must be amortized over the life of the loan when you refinance. To determine the deductible amount, divide the amount you paid by the number of months of the loan, then multiply that result by the number of months you had the loan during 1992. For example, you refinanced in February and paid $2,000 in points for a new 30-year loan. You can deduct $61 in 1992. That’s $2,000 divided by 360 months (12 times 30 years) equals $5.55, times 11 months.

Q: What does “under normal circumstances” mean? When are the points on a refinance immediately deductible?

A: Points are fully deductible in the year paid when you first buy a home, says Philip Holthouse, partner at the accounting firm of Holthouse Carlin & Van Trigt in Los Angeles. But, in a few cases, taxpayers who had short-term “balloon” loans were able to immediately deduct all the points they paid on a refinance too. Why? They successfully argued that their refinancing costs were purchase-related because the first loan was just a “bridge” that allowed them to do the transaction.

Q: What if I refinanced a vacation property?

A: If the mortgages on your residence and vacation properties add to less than $1.1 million, all the mortgage interest is tax deductible. Deductions for points have to be spread over the life of the loan--just like they are on a residence loan. None of the fees are deductible.

Q: What about an investment property?

A: That depends. Costs of refinancing an investment property fall into “passive loss” rules, which are complicated because the rules vary based on your income. Under such rules, losses from such “passive” activities as rental property can only be deducted against income from the same type of activities, not against ordinary income from wages and salaries.

But if you earn less than $100,000, you can subtract up to $25,000 in passive losses--including the cost of points and refinancing fees--from ordinary income. You have to amortize these costs over the life of the loan, however.

For example, you refinanced a 15-year loan in February and paid $3,000 in points and another $1,000 in escrow, title, loan origination and miscellaneous fees. You get to write off $244 on your 1992 return, which is $4,000 divided by 180 (12 times 15 years), times 11 (months you had the loan in 1992).

But if your income is more than $150,000, you can only write off costs against passive income. So you can offset the cost against rental income but not wages.

If your income is between $100,000 and $150,000, you may be able to write off some of the costs against ordinary income.

Q: When I refinanced, I got cash out to make home improvements and pay off a car loan. Does that change what’s deductible?

A: Probably. If the improvements were substantial, you can deduct that portion of the points immediately. For instance, you borrowed $100,000--$60,000 to pay off the existing mortgage, $20,000 to build a pool and $20,000 to buy a car. The portion of the points related to the home improvements--in this case, that’s 20% of what you paid--are deductible immediately. The rest must be amortized over the life of the loan.

As for what went to pay for the car: You get a tax break that allows you to deduct the interest and points on up to $100,000 in home equity debt no matter what the real purpose of the loan. But if you already have a $100,000 home equity loan outstanding, that portion of interest and points on the new loan are not deductible.