15.7 Interest on Refinanced Loans

When you refinance a mortgage on a first or second home (15.1) for the same amount as the remaining principal balance on the old loan, there is no change in the tax treatment of interest. In other words, if interest was fully deductible on the old loan, then it is fully deductible on the new loan.

If you refinance a home mortgage for more than the existing balance, the deductibility of interest on the excess amount depends upon how you use the funds and the amount of refinancing. If the excess amount is used to buy, build, or substantially improve your first or second home, then it is considered home acquisition debt (15.2). If the excess plus all other home acquisition loans does not exceed $1 million ($500,000 if married filing separately), the interest is fully deductible. If the excess is used for any other purpose, such as to pay off credit card debt or to finance a child’s education, the excess is considered home equity debt (15.3). If the excess plus all other home equity loans does not exceed $100,000 ($50,000 if married filing separately), the interest is fully deductible. If the refinanced loan is partly home acquisition debt and partly home equity debt, the overall limit of $1.1 million applies ($1 million home acquisition debt and $100,000 home equity debt) or, if married filing separately, $550,000 ($500,000 home acquisition debt and $50,000 home equity debt).

Interest paid on loans in excess of home acquisition and home equity debt ceilings is generally treated as nondeductible personal interest unless the proceeds are used for business or investment purposes (15.12).

EXAMPLE
In 2002, Robert and Michelle Stein purchased a home for $250,000. They put $50,000 down and obtained a $200,000, 30-year mortgage secured by the home. In 2012, when their house is worth $300,000 and there is a $175,000 principal balance on the mortgage, they refinance to take advantage of lower interest rates. The refinanced mortgage is for $225,000, payable over 20 years. The Steins use $175,000 to pay off the old mortgage, $30,000 to purchase a car and to pay off credit card debt, and the remaining $20,000 to build a new deck on their home.
The interest on up to $175,000 of the debt incurred to pay off the old mortgage is fully deductible; the amount equals the outstanding balance before refinancing and also falls within the $1 million home acquisition debt ceiling. The $20,000 used to remodel the house is also treated as home acquisition debt. Interest on this amount is fully deductible; the amount falls within the $1 million ceiling when added to the $175,000.
The $30,000 used to buy a car and pay off credit cards is treated as home equity debt. Interest on this amount is fully deductible; the amount falls within the $100,000 ceiling.

Pre–October 14, 1987 loans.

Refinanced pre–October 14, 1987 loans are not subject to the $1 million home acquisition and $100,000 home equity debt ceilings during the period of the original loan term. However, after the end of the loan term, the ceilings apply to the refinanced amount as explained above. Furthermore, where a refinanced pre–October 14, 1987 debt exceeds the remaining principal balance, the excess is also subject to the $1 million home acquisition and $100,000 home equity debt ceilings.

Points Paid on Refinancing

The IRS does not allow a current deduction for points on a refinanced mortgage. According to the IRS, the points must be deducted ratably over the loan period, unless part of the new loan is used for home improvements. Thus, if you pay points of $2,400 when refinancing a 20-year loan on your principal residence, the IRS allows you to deduct only $10 a month, or $120 each full year.

A federal appeals court rejected the IRS allocation rule where points are paid on a long-term mortgage that replaces a short-term loan; see the Court Decision in this section (15.7).

If part of a refinancing is used for home improvements to a principal residence, the IRS allows a deduction for a portion of the points allocable to the home improvements.

EXAMPLE
In June 2012, Craig Smith refinances his home mortgage, which has a principal of $80,000 outstanding. The new loan is for $100,000, payable over 15 years starting in July 2012. He uses $80,000 to pay off the old $80,000 balance and the remaining $20,000 is used for home improvements. Assume that at the closing of the new loan, Smith pays points of $2,000 from his separate funds. In 2012, the year of payment, he may deduct $400 allocable to the 20% of the loan used for home improvements. He may also deduct the ratable portion of the $1,600 balance of the points, which must be deducted over the period of the new loan. The ratable portion is $53 ($1,600 ÷ 180-month loan term × 6 months in 2012). Thus, Craig’s total deduction for points in 2012 is $453 ($400 + $53).

Mortgage ends early.

If you are ratably deducting points on a refinanced loan and you refinance again with a different lender, or the mortgage ends early because you prepay it or the lender forecloses, you can deduct the remaining points in the year the mortgage ends (15.8).

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