The Tax Cuts and Jobs Act of 2017 changed many of the rules for mortgage and refinance deductions. Understanding the new tax rules can help you minimize your tax burden after you refinance. We’ll talk about some of the deductions you can claim on your federal taxes after a refinance, and how long you can claim them.
2019 Tax Deduction Rules
A deduction is an expense that can lessen your tax burden. You reduce the overall amount of money that you need to pay taxes on when you take a deduction. For example, if you earn $50,000 a year before taxes and you have $5,000 worth of deductions, you’d only pay taxes on $45,000 of your income. There are select deductions that you can take after you refinance your mortgage loan.
New tax laws raised the standard deduction for both single and married filers. However, in exchange, many of the deductions homeowners could claim before are no longer available or are less substantial than before. For example, the Tax Cuts and Jobs Act restricted the interest deduction on most mortgage loans. It also removed the insurance deduction on most mortgage loans. In the next section, we’ll go over a few specific deductions you can take advantage of during the year you refinance and beyond.
One of the first questions that most homeowners have when they consider a refinance is about the type of income rules that apply to cash-out refinances. When you take a cash-out refinance, you take on a higher loan principal and your lender gives you the difference in cash. But is this cash considered income – and do you need to report it on your return?
The IRS doesn’t consider the cash from a cash-out refinance as income. Instead, they consider it to be a debt restructuring. This means that you don’t need to report any cash you take out of your home equity as income.
What Can You Deduct From Your Income Taxes?
Let’s take a look at a few expenses you can deduct after you take a refinance.
The biggest deduction you’ll usually qualify for is the mortgage interest deduction on both your original loan and refinance. However, special rules apply for deducting interest on a cash-out refinance.
First, let’s talk about mortgage interest on a standard rate and term refinance. You can deduct any interest paid on your refinanced loan if all of the following conditions apply:
- The loan is for your primary residence or a second home that you don’t rent out.
- The lender that finances your home has a lien on your property. That means that if you fall behind on your payments, your lender can seize your property or put your loan into foreclosure.
- You itemize your tax return – we’ll go over more about what that means in a bit.
The rules are a little different if you opt for a cash-out refinance. You may deduct the interest on your original loan balance no matter how much equity you take out of your home. However, you may do this only if you use the money to make capital improvements.
A capital improvement is any permanent addition you make to your home that increases its value. Some examples of capital home improvements include:
- Installing a remote-controlled garage door where a manual door used to be
- Adding a swimming pool, spa or jacuzzi to your backyard
- Replacing your roof
- Building a home office or adding another bedroom to your home
Capital home improvements don’t have to be expensive. Some examples of smaller capital home improvements include:
- Replacing your windows with storm windows
- Adding a home security system
- Installing a central heating and cooling system
Remember that only permanent additions or renovations count as capital home improvements. Repairs and aesthetic changes (like painting a bedroom) don’t count toward the overall value of your property. That means you cannot deduct anything if you use the money to make home repairs or small design changes. You also cannot deduct the interest on your cash-out refinance if you use the money for any other purpose, like paying off credit card debt or taking a vacation.
Let’s take a look at an example to illustrate this point. Let’s say that you have a mortgage with an $80,000 principal. You know you want to take out $20,000 of your equity with a cash-out refinance but you don’t know what you want to spend it on. You have two options: You can add a swimming pool to your backyard or pay off your credit card debt.
A swimming pool is a capital improvement to your home. This means that you can deduct all the interest on your total loan balance – that’s $100,000 after the refinance. However, you may pay off your credit card debt but then can only deduct the interest on your original balance – $80,000. This means you can only deduct 80% of the total interest you paid.
You may have the option to buy discount points when you close on your loan. Discount points reduce your interest rate. Each point costs 1% of your total loan value. For example, if you refinance a loan with a $150,000 principal, each point costs $1,500. You might hear a lender refer to this as “buying down” your interest rate.
Discount points are fully deductible, no matter which type of property you’re refinancing. You can also deduct discount points on both regular and cash-out refinances.
Closing Costs On A Rental Property
You cannot deduct settlement fees and other closing costs on a primary or secondary home. However, different rules apply for rental properties. The IRS sees the money you earn from renting out a home or condo as taxable income.
You have a lot more leeway when deducting closing costs and other upkeep expenses for a refinance on a rental property. Some expenses you can claim as deductions on a rental property include:
- Attorneys’ fees
- State-required inspection fees
- Refinance application fees
- Legal and recording fees
- Appraisal fees
In addition, you can also deduct insurance and repair expenses related to a rental property.
How Long After A Refinance Can I Claim A Tax Deduction?
You can deduct most closing costs over the life of your refinance. This means that if you refinance your mortgage to a 15-year term, you must spread your deductions between 15 years of tax returns. Let’s take a look at how this works in practice.
You may deduct the interest paid on your refinanced loan as long as you meet the criteria laid out above. You can claim the deduction every year that you make payments on your loan. However, you can only deduct the interest that you paid during that year. For example, you might pay $1,000 on your mortgage loan during the 2019 tax year but you can only deduct $1,000 from your taxes. This means that as your loan gets closer to maturity, you’ll be able to claim less and less in interest deductions because more of your payments go toward the principal.
Not sure how much money you paid in interest this year? Your mortgage lender will send you a document called Form 1098 at the beginning of each new tax year. This is your Mortgage Interest Statement, and it tells you exactly how much you paid in interest. You don’t need to include a copy of your Form 1098 with your tax return, but your lender is responsible for forwarding the IRS a copy. If you don’t receive a Form 1098 by mail or you have questions about the balance on your statement, contact your lender.
Discount Points And Closing Costs
You cannot deduct the total amount that you paid at closing the year that you refinance if you buy discount points. Instead, you must spread your deductions over the total course of your loan. For example, let’s say that you paid $5,000 at closing for discount points. Let’s also say that your refinanced loan has 10 years left on its term. You would only be able to deduct $500 per year from your federal taxes. However, you can claim this deduction every year until your loan matures.
The same rules apply for closing costs on a rental property refinance. For example, if you spent $15,000 on closing costs for a 15-year refinance, you’d deduct $1,000 a year until your loan matures.
Remember that tax laws can change on a year-to-year basis. If you aren’t sure about the rules for this year, consider speaking to a CPA or other tax professional.
Mortgage Tax Deduction Restrictions
Keep in mind that most deductions only apply for homeowners who itemize their deductions. This means adding up all the individual deductions you qualify for and deducting them from your taxable income. You may choose to itemize your deductions or take the standard deduction. The standard deduction is a single deduction that anyone can claim, no questions asked. The standard deductions for 2019 are as follows:
- $12,200 for single filers
- $24,400 for married couples filing jointly
You cannot deduct things like interest and mortgage points if you take the standard deduction. This rule applies for both primary residence refinances as well as investment property deductions.
A deduction is a subtraction you can claim on your federal taxes that reduces your tax burden. There are a number of tax deductions that you can take advantage of if you refinance a mortgage loan. You can deduct the full amount of interest you pay on your loan in the last year if you did a standard refinance on a primary or secondary residence. You can only deduct 100% of your interest if you take a cash-out refinance, particularly if you use the money for a capital home improvement. Otherwise, you can only deduct the percentage of interest you paid on your original loan balance.
You can also deduct your discount points and any closing costs you pay toward a refinance on an investment property. You must spread these costs over the total term of your refinance and can only deduct these expenses if you itemize your deductions.
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