As interest rates fell through 2020, mortgage refinancing became a key way to save money amid the coronavirus pandemic. However, those who have taken the plunge need to be clear about how the decision to refinance can affect their taxes when it comes to deductions.
The Mortgage Bankers Association estimated that lenders took out around 7.1 million refinancing loans over the past year. "The vast majority of owners won't even qualify for tax deductions," said Holden Lewis, real estate and mortgage expert on personal finance website NerdWallet.
The Tax Cut and Jobs Act of 2017 ultimately retained the mortgage interest deduction, albeit with some changes after some suggested that the GOP might decide to ditch it.
However, the Republican Tax Preform Package expanded the standard allowance to $ 12,000 for individual applicants and $ 24,000 for joint tax returns. With the expansion of the standard deduction, Republican lawmakers set a high bar for the breakdown of deductions to give taxpayers more financial sense.
And with interest rates so low right now, most homeowners don't pay enough interest every year to make the deduction worthwhile unless they have other deductions to avail, experts say.
As a result, only "a really small subset of homeowners" have to worry about how the mortgage interest deduction was changed, "said Lewis.
How the mortgage interest deduction has changed
The Tax Reduction and Employment Act has reduced the amount of mortgage debt on which interest is deductible. Prior to the legislation, homeowners could deduct up to $ 1 million in interest on mortgage debt if the original loan used to buy, build, or improve a home was taken out between October 1987 and December 2017. (For home loans purchased prior to 1987, mortgage interest on the entire loan amount may be deductible depending on eligibility.)
After the tax reform package came into effect, the limit on the deduction of mortgage interest was lowered. As of 2017, homeowners could only deduct interest on mortgage debt up to $ 750,000 that was used to buy, build, or improve a home. Homeowners with pre-existing mortgages have been treated like grandfathers, which means they can continue to deduct interest on mortgage debt of up to $ 1 million if they receive the loan before the 2017 deadline.
As of 2017, homeowners could only deduct interest on mortgage debt up to $ 750,000.
What does it all mean if you only refinanced last year? If your new loan was less than $ 750,000, you probably understand. "If you only refinanced your existing balance (for the loan) at this point and it was less than $ 750,000, you will receive the full interest deduction," said Ryan Losi, certified public account and executive vice president of Piascik, an accounting firm with Based in Virginia.
And if your original mortgage was prior to 2017, you may be able to deduct interest on debt up to $ 1 million. "To know what limit applies (the older $ 1 million or the newer $ 750,000), refinance generally refers to the date of the original loan for the purpose of mortgage interest deduction," said Tim Todd, auditor and member the Financial Literacy Commission of the American Institute of CPAs.
How have the loan proceeds been used?
Many homeowners who took advantage of the low interest rate last year to complete a withdrawal refinance – which means that the principal on the new loan was greater than the original mortgage because they borrowed some of the equity they built up.
But if someone refinances more than the original loan, they are subject to the new limits set by the 2017 law, Todd said.
But even then, the amount added may or may not be deductible. "Now you need to apply the interest tracking rules to tell what that revenue has been used for," Losi said.
The Internal Revenue Service states on its website that additional debt raised through a refinance that is "not used to buy, build, or significantly improve a qualifying home is not a home acquisition debt."
"You have to follow the interest tracking rules to say what that revenue has been used for."
Let's say the original mortgage balance was $ 450,000, but the borrower refinanced and paid out another $ 50,000. You can potentially subtract the interest on up to $ 500,000 on this mortgage debt depending on how they used the money they paid off. If you've funded a renovation, like converting a bedroom into an office, you know. If you use it to pay your child's tuition fees or buy a new car, only the original balance can be deducted.
In addition, the IRS clarified that "the new debt will only count as home equity up to the amount of the balance of the old mortgage equity immediately prior to refinancing." If a homeowner pays off through a refinance and is above the current limit of $ 750,000, the additional amount may not be eligible.
Continue reading: Did you skip mortgage payments last year? This means the following for your taxes