Evaluate the tax ramifications of refinancing your residential mortgage

With record low interest rates many individuals are evaluating the pros and cons of refinancing.

Due to the mortgage crisis of a few years ago, residential mortgage refinancing is much more complicated than it was in the past. In certain instances home values are lower and the paperwork requirements are higher.

When you refinance the mortgage one of the most important points is the length of term for repayment. Bankrate.com suggests a borrower reduce the term of refinance can save thousands of dollars of interest. "If you want to do long term damage to your personal finance, start all over again by refinancing for a full, 30 year term. That way, you spend thousand of dollars on interest that you otherwise could have saved. Reducing the term of a mortgage by just five years can yield big savings. On a $200,000 mortgage at 5 percent, a borrower can save $35,758 in interest by paying off the loan in 25 years instead of 30. Pay off the loan in 20 years instead of 30, and you save $69,733 in interest.

In addition to the reduction in interest rates by refinancing, a borrower has to understand the tax rules.

The mortgage interest deduction is currently available for interest expense on loans secured by your principal home or a second home.

The Internal Revenue Code allows you to deduct interest on up to $1 million on "acquisition indebtedness" that is, debt used to by, built or substantially renovate a home, plus interest on up to $100,000 in home equity debt used for any purpose. These limits apply to combined principal of every loan that's secured by your principal and second home. This is subject to marital status limitations. Homeowners who have more than $1 million in acquisition indebtedness may deduct interest on the excess as home equity debt, subject to the $100,000 limit.

Borrowers have to understand that tax rules on refinancing versus cashing out financing on your residence. When one refinance a residential mortgage with a replacement loan, you can borrow an amount equal to the outstanding balance on the existing mortgage. The interest on the new mortgage is fully deductible, provided that your total acquisition indebtedness is no more than $1 million.

For borrowers who want to cash out refinancing, in which you borrower more than you need to cover your existing mortgage indebtedness, the tax treatment depends on how use the excess proceeds. If you use the excess proceeds for home improvements (additions and renovations to the residence), these proceeds are considered acquisition indebtedness, and the interest is deductible (subject to the $1 million limitation). If you use the excess cash for another purpose, such as buying a car, boat, or paying tuition, the interest is considered home equity debt subject to the $100,000 limit.

In many instances, individuals who refinance their mortgage prefer not to pay "points" for the refinancing. If you pay "points" for the refinancing, the IRS considers this expense as prepaid interest which is amortized and deductible over the life of the loan. For example, if you refinanced a $750,000 mortgage with a new 25 year loan, paying two points, (a fee of $15,000), and then the borrower is allowed to deduct $600 of interest each year.

One final suggestion, since I am not a practicing accountant, please seek professional advice regarding the tax implications of refinancing.

Posted on October 23, 2012 .