A review of the tax angles clients should be aware of when they consider refinancing their home loans.
With some experts predicting that home mortgage rates will rise, homeowners with adjustable-rate mortgages or higher-interest fixed rate mortgages obtained years ago may be motivated to refinance now.
Others may find that refinancing a loan to renovate or expand a home may be more cost effective than trading up to another home.
Deductions from exiting the old mortgage. Prepayment penalties are deductible as interest subject to the rules of Code Sec. 163. (Rev Rul 57-198, 1957-1 CB 94) Thus, if there’s a penalty for paying off a mortgage early, it’s fully deductible if the retired debt itself qualified as acquisition debt or home-equity debt under Code Sec. 163(h)(3). Additionally, if the borrower had to deduct points over the life of the old mortgage, the remaining unamortized portion of the points charge generally may be deducted currently as interest (again, assuming the underlying loan qualified). (PLR 8637058; IRS Publication 936, 2016, pg. 8)
However, if the mortgage loan is refinanced with the same lender, IRS says the remaining balance of capitalized points must be deducted over the term of the new loan, not in the year the prior mortgage ends. (IRS Publication 936, 2016, pg. 8)
Points on the new loan. If the conditions of Code Sec. 461(g)(2), Reg. § 1.6050H-1(f)(1) and Reg. § 1.6050H-1(f)(2) are satisfied, points paid in connection with the purchase or improvement of a principal residence are currently deductible. IRS says that points paid on a refinance loan are deductible.
1. Only if the borrower pays the charge out of his own cash at the closing (e.g., the charge isn’t withheld from the mortgage loan), and
2. Only to the extent the proceeds are used to improve the residence. (Rev Rul 87-22, 1987-1 CB 146; Rev Proc 92-12, 1992-1 CB 662, Sec. 4.04)
The currently deductible amount is based on the ratio of borrowed funds used for improvements to the total amount of the loan. (Rev Rul 87-22, 1987-1 CB 146) The balance of the points is deductible over the term of the new loan.
The Eighth Circuit has ruled that a taxpayer who financed the purchase of a residence with a 3-year mortgage loan, and then refinanced in the third year, could currently deduct the points on the refinance loan. (Huntsman, James, (1990, CA8), 905 F2d 1182, 66 AFTR 2d 90-502066 AFTR 2d 90-5020 revg & remdg (1988) 91 TC 91791 TC 917) However, IRS won’t follow Huntsman outside of the Eighth Circuit. (AOD 1991-002,2/11/1991) And the Tax Court has said that the Eighth Circuit’s rule does not apply where the original loan was a 30-year loan and the purpose of the refinancing was to obtain a lower interest rate and a fixed rather than variable interest rate. (Kelly, David, (1991), TC Memo 1991-605TC Memo 1991-605)
How to handle points that can’t be claimed currently. If points aren’t currently deductible under Code Sec. 461(g)(2), they generally must be deducted over the life of the loan using OID-type economic accrual principles. However, IRS says it will, as a matter of administrative convenience, allow a borrower to find the amount deductible annually by:
1. Dividing the non-currently-deductible points charge by the number of monthly payments to be made on the loan, then
2. Multiplying the result by the number of mortgage payments made during the tax year.
This expedient is available only if the points are paid in connection with a loan of not more than $250,000 that:
1 Is payable over no more than 30 years;
2 Is secured by a residence; and
3 Carries no more than six points if the loan term exceeds 15 years, or no more than four points for shorter loans. (Rev Proc 87-15, 1987-1 CB 624)
Observation: The economic accrual method “front loads” the deductible amount (higher deductions in the early years, smaller ones in the later years), whereas the easier-to-calculate ratable method produces a level deduction figure through the loan term.
Deducting interest on the new loan. Interest paid on the refinance loan generally will be deductible under the following rules, assuming it is properly secured and all of the other Code Sec. 163(h)(3) conditions are met:
1. The new loan proceeds are treated as qualified acquisition debt to the extent the new loan amount doesn’t exceed the balance remaining on the original mortgage. Interest paid on qualified acquisition debt of up to $1 million is fully deductible. (Code Sec. 163(h)(3)(B))
2. Borrowed funds in excess of the amount necessary to retire the old mortgage also are treated as acquisition debt to the extent used for “substantially improving” the residence. (Code Sec. 163(h)(3)(B)(i)(I)) IRS says that any improvement that adds to the home’s value, prolongs its useful life, or adapts the home to new uses qualifies as “substantial”. Repairs that maintain a home in good condition, such as repainting the home, are not substantial improvements. But if the taxpayer paints the home as part of a renovation that substantially improves the qualified home, he can include the painting costs in the cost of the improvements. (IRS Publication 936, 2016, pg. 10)
3. To the extent they aren’t used for substantial improvements, borrowed funds in excess of the amount necessary to retire the old mortgage may be treated as home-equity debt. Generally, the interest paid on up to $100,000 of home equity debt is deductible regardless of how the proceeds are used. (Code Sec. 163(h)(3)(C))
Caution: Even if all of the home-equity debt provisions are met, the interest won’t be deductible to the extent the deduction is disallowed by another provision such as the Code Sec. 265(a)(2) prohibition against deducting interest on debt to buy or carry tax-exempt bonds. (Reg. § 1.163-8T(m)(1)(ii))
Special rules apply for certain refinanced grandfathered debt (generally, debt incurred before Oct. 13, ’87).
Part principal residence, part business property. A person’s home may be used partly for business purposes (e.g., office at home, professional’s office, or rented to others). In these cases, allocations are required, and part of the loan automatically will be disqualified from the favorable qualified residence interest rules. That’s because residence interest is deductible only to the extent the loan is secured by the taxpayer’s principal residence (his or her main home) or another property treated as a residence under the Code Sec. 280A(d)(1) vacation home rule. Thus, to the extent the loan is secured by a home office or rented rooms, it can’t be qualified debt. (Code Sec. 163(h)(4)(A); Reg. § 1.163-10T(p)(4)) No allocation is required, however, if the tenants are residential, there aren’t more than two different tenants, and the rented portion isn’t a self-contained living unit with separate sleeping space and toilet and cooking facilities.
© 2017 Douglas Rutherford, CPA, CGMA, CPLA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.