photo credit: woodleywonderworks
With the lowering of interest rates and especially mortgage interest rates, lots of people, including me, are investigating whether or not to refinance their homes. But in your quest to get the lowest interest rate, make sure you don’t leave money on the table! What money you ask? The tax breaks that come from refinancing. Many people are unaware of a potentially lucrative tax break available to homeowners who refinance their home and in the process, pay “points.”
Also called loan discounts or origination fees, points are paid at closing. One point represents 1 percent of your mortgage loan amount. For example, if your mortgage is for $150,000 and you agree to pay one point, you would owe $1,500 at the closing table. This amount is paid to the bank or lending institution.
On your first mortgage (your primary residence), points are deductible in the year they’re paid. In the above example, you would be allowed to deduct the $1,500 all at once. But when you refinance, you’re required to amortize the points over the life of the loan. If you paid one point to refinance a $150,000, 30-year mortgage, you would only be allowed to deduct $50 per year.
And that’s that, unless you decide to refinance a second time. In that case, you may be allowed to deduct the amount of un-amortized points the year you refinance.
Suppose, for example, you refinanced a $150,000 loan three years ago and paid one point, and using the amortization schedule, you deducted $50 on your taxes each of the last two years. But rates have fallen since then, so you’ve decided to refinance again. When you file your taxes for the year you refinanced — in this example, 2008 — you can deduct the remaining $1,450.
To deduct un-amortized points, you must meet certain requirements from the IRS, including:
- If you refinance with the same lender, you can’t deduct the balance of your points. You have to deduct the balance over the term of your new mortgage loan, according to the IRS. On average, only about one in five borrowers refinance with the same lender, but it’s worth considering when comparing an offer from your existing lender with those from other financial institutions.
- This tax break only applies to your primary residence, not vacation homes, RV’s, boats, etc. Points on a second home must always be amortized, whether it’s for a first mortgage or for refinancing.
- If you refinance to not only get a lower interest rate, but to also fix up your home, you can deduct the percentage of the points related to the improvement costs for the year you refinance. For example, suppose you decide to refinance your mortgage with a 15-year, $150,000 loan, locking in a lower rate by paying one point, or $1,500. You use $100,000 to repay your existing mortgage and $50,000 to renovate your kitchen and add a new bathroom. Because your home improvement costs represent 33% of the new loan, you can deduct 33% of your points, or $500, the year you refinance. The balance has to be amortized over the life of the loan.
- According to the IRS, if you pay off your mortgage early, you can deduct any unamortized points in the year the mortgage is paid off.
- If you’re penalized for paying off your mortgage early, that fee is deductible.
- If you were late on a few payments and had to pay some penalties, those fees are also deductible. These penalties should be listed on Form 1098, the annual tax document sent to you by your lender.
Finally, it’s important to understand the difference between points and the myriad of other expenses associated with both new mortgages and refinanced loans.
Points are deductible because they’re considered prepaid interest, and (at least for now) interest on a home mortgage is deductible. Your settlement statement should clearly state that points were paid on the loan.
Appraisal fees, mortgage insurance premiums and other administrative costs are annoying, but they’re not deductible. Don’t make the mistake of having your mortgage broker call them points so you can deduct them! For more information, see IRS Publication 936 and be sure to consult with your tax adviser.