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With home mortgage rates at their lowest level in years, you may be considering refinancing your adjustable rate or higher interest rate mortgage to lock in what looks like a real bargain. Although taxes take a back seat to the basic issue of whether refinancing saves enough money to be worthwhile, you should be aware of the basic tax rules that come into play. In some cases, you may be pleasantly surprised at the tax deductions you'll be able to claim as a result of refinancing. In some circumstances, however, you may wind up with fewer deductions than you had expected.
The most widely applicable rules are as follows:
What these rules boil down to is that the interest you pay on the new loan usually will be deductible if:
Points paid in connection with buying or substantially improving your main home are currently deductible. However, if you must pay points on a refinance loan, this charge will be currently deductible only if you pay the charge out of your own cash at the closing (that is, the charge is not withheld from the mortgage loan) and only to the extent that the new loan proceeds are used to substantially improve your home. So if you refinance your existing home mortgage and use none of the new loan for substantial improvements to your home, any points you pay on the transaction wont be currently deductible. Instead, you'll have to deduct the points over the life of the new mortgage.
You may have to pay the bank a prepayment penalty to pay off your existing mortgage. If that's the case, the penalty will be fully deductible if the interest you paid on the retired mortgage was deductible as home mortgage interest.
You may have had to pay points when you got the mortgage you now want to refinance. If you were required to deduct the points over the life of your existing mortgage, the part of the points that you haven't yet deducted may be deducted currently as interest (again, assuming that the interest you paid on your existing mortgage was deductible as home mortgage interest).
For example, suppose you refinanced your home mortgage several years ago and used the proceeds to pay off in full your original home mortgage. Your refinancing mortgage (loan #2) was a 30-year fixed rate loan for $100,000. You paid three points ($3,000) on the refinancing. Because all of the loan proceeds were used to pay off the original mortgage and none were used to buy or substantially improve your home, all the points on the refinancing loan had to be deducted over the loan term. This year, you refinance again with a lower interest mortgage (loan #3) when there's a remaining (not-yet-deducted) points balance of $2,400 on loan #2. You can deduct the $2,400 as home mortgage interest in the year loan #2 is paid off.