What are the tax considerations associated with refinancing and home equity loans?
Generally, interest paid on loans to acquire an existing home or to construct a new home is tax deductible (with certain limitations; see Home Mortgage Interest Deductions for more details). In addition, interest paid on refinanced mortgages is deductible (also subject to certain limitations).
Can you deduct interest paid on refinanced mortgages?
If you refinance the current principal balance owed on a mortgage secured by your primary or secondary residence (a no-cash-out refinance), interest on the refinanced loan will be deductible to the same extent as was the interest on the old loan. If, however, the refinanced loan is for more than you owed on the old loan (a cash-out refinance), deductibility of interest on the amount of the loan that exceeds the principal balance of the old loan is determined as follows:
- If you use the excess amount to buy, build, or substantially improve your first or second residence, the excess amount is treated as home acquisition indebtedness. It is therefore subject to the rules and limitations that apply to such debt (i.e., interest paid on mortgages of up to $1 million–or $500,000 if you're married and filing separately–is deductible). For more information, see Home Mortgage Interest Deductions.
- If the excess is used for any other purpose, it is considered home equity debt and is subject to the rules and limitations applying to such debt (i.e., interest on up to $100,000–or $50,000 if you're married and filing separately–is deductible). Lower limitations may apply in certain circumstances.
What if part of the excess of a cash-out refinance mortgage is used toward buying, building, or substantially improving your first or second residence and part is used for other purposes?
Here, the former amount is treated as home acquisition debt, and the latter amount is treated as home equity debt.
Example(s): Suppose you took a mortgage of $150,000 to purchase a home costing $200,000. Eight years later, when your home's fair market value is $250,000 and you owe $135,000 on the original loan, you take a cash-out refinance mortgage of $190,000 on your home. (Assume you are married, file jointly, and have no other mortgages on the home.)
All of the interest on the first $135,000 of the new loan is considered remaining home acquisition debt and is fully deductible (because it does not exceed the $1 million limitation).
Of the $55,000 excess ($190,000 borrowed minus $135,000 owed), you use $30,000 to add a bathroom to your home and $25,000 to pay off bills and buy a car. The $30,000 will be considered home acquisition debt, and interest on it will be fully deductible, since you're still within the $1 million limitation. The $25,000 will be considered home equity debt and will also be fully deductible, since you are within the $100,000 limitation.
Special rules for pre-October 14, 1987, refinance mortgages
If you refinanced a loan on your primary or secondary residence before October 14, 1987, it will be subject to neither the $1 million/$500,000 home acquisition debt limit nor the $100,000/$50,000 home equity debt limit, as long as the amount borrowed does not exceed the remaining principal balance on the old loan (i.e., as long as it was a no cash-out refinance).
Caution: If, however, the loan you took was a cash-out refinance, then the excess borrowed will be subject to the home acquisition and home equity debt limitations.
For more information about refinances and home equity loans, see Home Mortgage Interest Deductions.
Vikram Kohli, MBA, CRPC®
Ameriprise Financial Services
3130 De La Cruz Blvd.
Santa Clara CA 95054
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