April 17, 2005 - Tax implications of refinancing your home. I was considering refinancing my home, but I am unclear on the tax implications of doing so. Can you explain some of the issues for me?

What portion of my mortgage payment is deductible on my tax return?

Only the interest that you pay on a home mortgage is deductible within limits, depending on whether it is home acquisition debt, home equity debt, or grandfathered debt. When you refinance your mortgage, the interest will be deductible if it falls into one of these categories, as explained below.

Home acquisition debt is a mortgage you took out after Oct. 13, 1987, to buy, build, or substantially improve your main or second home, and that is secured by that home. Interest on home acquisition debt is deductible, but your total home acquisition debt can't exceed $1 million.

Home equity debt is any debt secured by your first or second home, other than home acquisition debt, or grandfathered debt. So it includes mortgage loans taken out for other reasons, and mortgage debt in excess of the home acquisition debt limit. Interest is deductible on up to $100,000 of home equity debt.

Grandfathered debt is mortgage debt secured by your first or second home that was taken out before Oct. 14, 1987, no matter how you used the proceeds. All of the interest you pay on grandfathered debt is fully deductible. (We won’t discuss grandfathered debt further in this article.)

Refinancing. If the old mortgage that you are refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, up to the principal balance of the old mortgage just before it was refinanced. The interest on this portion of the new mortgage will be deductible. Any debt in excess of this limit won't be home acquisition debt, but it may qualify as home equity debt, subject to the $100,00 limit.

When I refinance my mortgage and get charged points is there any tax savings available for these costs?

In general, points that you pay to refinance your home aren't fully deductible in the year that you paid them. Instead, you can deduct a portion of the points each year over the life of the loan.

To figure your deduction for points, divide the total points by the number of payments to be made over the life of the loan. Then, multiply this result by the number of payments you made in the tax year.

For example, if you paid $3,000 in points and you will make 360 payments on a 30-year mortgage, you can deduct $8.33 per monthly payment. For a year in which you make 12 payments, you can deduct a total of $99.96 ($8.33 × 12).

However, you may be entitled to a larger first-year deduction for points if you used part of the proceeds of the refinancing to improve your home and you meet certain other requirements. In that case, the points associated with the home improvements may be fully deductible in the year they were paid.

For example, say that you refinance a high-rate mortgage that has an outstanding balance of $80,000 with a new lower-rate loan for $100,000. You use the proceeds of the new mortgage loan to pay off the old loan and to pay for $20,000 of improvements to your home. Since 20% of the new loan was incurred to pay for improvements, 20% of the points you paid can be deducted in the year of the refinancing.

If you are refinancing your mortgage for the second time, the portion of the points on the first refinanced mortgage that you haven't yet deducted may be deductible at the time of the second refinancing.

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