A Guide to the Tax Rules of Mortgage Refinancing

Recent drops in interest rates have prompted millions of households to refinance their mortgages. Borrowers who refinance need to familiarize themselves with tricky tax rules on what is or isn't deductible for interest payments. Here are some reminders on how the rules work.

Consider a client who owns a personal residence. It's worth more than the remaining principal balance on the mortgage. The lender is willing to allow a refinance for more than the balance of the existing mortgage. Tax rules allow the client to deduct interest payments on a refinancing loan as long as it's for the same amount as the existing balance. But is the client also entitled to deduct interest payments for the part of the refinancing that exceeds the existing balance? And does it matter that the client plans to use most of the excess refinancing proceeds to pay off credit card debts?

Whether borrowers are entitled to deduct interest on the excess amount depends upon how they use the proceeds from the refinancing and the amount of the proceeds. When borrowers use the amount in excess of the existing mortgage to buy, build or substantially improve principal residences, meaning year-round dwellings, or second homes such as vacation retreats, their interest payments come under the rules for home acquisition loans. Those rules allow them to deduct the entire interest as long as the excess plus all other home acquisition loans don't exceed $1 million ($500,000 for married couples filing separate returns).

However, when borrowers use the excess for any other purposes, another set of rules prohibits deductions for payments of interest on "consumer loans." This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts such as overdue federal and state income taxes. There is, though, a limited exception for interest on student loans, one of those "above-the-line" subtractions to arrive at adjusted gross income.
But most borrowers are able to sidestep these restrictions on deductions for consumer interest, thanks to the rules for home equity loans. Those rules allow them to deduct the entire interest as long as the amount in excess of the existing mortgage plus all other home equity loans don't exceed $100,000, dropping to $50,000 for married couples filing separate returns. It makes no difference how borrowers use the proceeds.

When their refinanced loans are partly home acquisition loans and partly home equity loans, there's an overall limit of $1.1 million, which is a combination of $1 million from the home acquisition debt and $100,000 home equity debt. (That number drops to $550,000 for married couples filing separately.) When the loans exceed the ceiling of $1 million for home acquisition loans and $100,000 for home equity loans, the excess generally is categorized as nondeductible personal interest. The general disallowance is subject to exceptions for loan proceeds used for business or investment purposes.

Yet another restriction applies to the steadily growing number of borrowers burdened by the alternative minimum tax. The AMT allows deductions for interest payments on home acquisition loans of up to $1 million ($500,000 for married couples filing separately). But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless the loan proceeds are used to buy, build, or substantially improve the dwellings.