Mortgage interest always becomes a major topic at tax time, so here’s some last-minute ammunition for those struggling to resolve confusing tax-deduction questions by the April 17 deadline for filing your 2005 income tax return.
You can deduct the loan fees (points) paid to buy or improve your primary home in the year of purchase. You cannot deduct these fees in the year you refinanced if you refinanced only to obtain a lower interest rate on your loan.
The term points once was used to describe only prepaid interest on government loans, now it’s for any charges paid by a borrower to secure any mortgage. Points can be loan origination fees or prepaid interest to buy down an interest rate. To be deductible, points must represent interest paid for the use of money and must be paid “before the time for which it represents a charge for the use of the money.”
According to the Internal Revenue Service, most points paid when you are refinancing an existing mortgage must be written off over the life of the new loan. However, if you sold a home in 2005, you can still deduct several items, including title insurance costs and excise taxes. For guidance on closing costs, the best source may be the settlement sheet from the original loan.
Points on refinancing are not fully deductible in the year in which they are paid because they were not paid in connection with the improvement or purchase of a home, even though the original loan met the requirements for deductibility.
What many home sellers forget to factor at tax time are the fees remaining from a previous refinance. All of those fees can be deducted in the tax year you choose to refinance a second time.
For example, let’s say you jumped at a 30-year, fixed-rate loan at 4.5 percent in May 2005. In order to get that lower rate, you had to pay at least 5 discount points. If the loan amount were $80,000, one discount point would amount to $800, and five points would be $4,000.
Points paid to buy, build or improve your principal residence can be deducted in the year they are paid, as long as they were not rolled into the loan amount. However, because you refinanced to simply obtain a lower interest rate, nearly all of the $4,000 must be written off over the life of the loan. That’s because the IRS sees refinancing points as repayment of existing debt.
In March, however, an unexpected need to send Dad into an assisted living home necessitates another refinance to pull some cash out of the home. You decide on an adjustable-rate mortgage with a very low starting rate and pay no fees. Now that the existing loan is paid off, the remaining balance of the fees from the previous loan is deductible in tax year 2006.
If you did refinance last year, double-check your numbers. You can only deduct interest on the amount of the loan at the time you refinanced, plus $100,000. For example, let’s say you purchased your home 10 years ago for $100,000 and took out a loan for $80,000. Since then, you have paid the loan down to $20,000.
The house is now worth $275,000 and your eldest child now needs college tuition. The house definitely has equity to tap, but your mortgage interest deduction would be limited to the first $120,000 ($20,000 old loan at the time of refi, plus $100,000).
It is important to remember that home-loan interest deductions simply reduce your taxable income. They are not dollar-for-dollar tax credits that are subtracted from your tax bill. If you have a $1,000-a-month mortgage payment and are in the 15 percent tax bracket, only about $150 a month escapes being taxed in the early months of the loan.
Unless you are haunted by an immediate want or need for a large sum of money – for example, for medical expenses or major investment – the decision to refinance should be based on how long you will be in your house. If you are going to be in the house fewer than three years, the fees and other costs may outweigh the lower interest rate.
And the tax deductions always seem greater than they really are.
Tom Kelly’s new book “Real Estate for Boomers and Beyond: Exploring the Costs, Choices and Changes for Your Next Move” (Kaplan Publishing) is available in retail stores, on Amazon.com and in local libraries.
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