Tax time: Refinance doesn’t reset mortgage interest deduction

Are you still feeling smug about nailing down a fixed-rate loan last year for less than four percent? Are you looking forward to a mortgage interest deduction on your federal tax return?

While homeowners who refinanced in the fourth quarter of 2012 were able to trim their interest rate by about 1.8 percentage points on average, many are unaware that the amount they can deduct on their Internal Revenue Service return is set at acquisition debt – the amount of debt in place when the home is acquired – minus amounts already paid on the loan.

For example, if you buy a $200,000 home with a $50,000 down payment, your acquisition debt is $150,000, minus any principal you have paid

Many consumers stay in their homes for years, accumulate appreciation and then refinance to put a child through school, mom into a nursing home or attend a much anticipated family reunion. The new debt on the refinance will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing.

For example, let’s assume your home is now worth $300,000 and you need to take cash out for a family emergency. The balance of your loan before you refinance is $135,000 and you take $100,000 “cash back” for a new loan balance of $235,000. However, the maximum allowable mortgage interest deduction remains $135,000 – the acquisition debt, not the bigger number from the refinance – minus principal you have paid.

Under the Internal Revenue Code, mortgage interest is deductible from income, but not to the extent that it is attributable to an outstanding mortgage principal balance of more than $1 million. Similarly, interest payable on a home equity line of credit that is used to finance home improvements is deductible, but not to the extent that it is attributable to an outstanding loan balance of more than $100,000.

Homes should never be purchased – or loans refinanced – simply for the mortgage interest deduction. Mortgage interest is not a dollar-for-dollar tax credit, rather the mortgage interest paid reduces taxable income.

According to the Internal Revenue Service, taxpayers will have until Monday, April 15, to file their 2012 tax returns and pay any tax due.

Taxpayers requesting an extension will have until October 15 to file their 2012 tax returns. Remember that an extension of time to file is not an extension of time to pay. You will owe interest on any past-due tax and you may be subject to a late-payment penalty if timely payment is not made.

The terrific, long-term news is that borrowers who refinanced last year received some of the best rates and terms in history. For example, those who refinanced in the fourth quarter received an average savings of about 33 percent on the interest rate – which Freddie Mac reports is the largest percentage reduction it’s ever recorded. In December, fixed mortgage rates had reached new lows, with 30-year products averaging 3.4 percent and 15-year averaging 2.7 percent that month.

“On a $200,000 loan that translates into saving about $3,600 in interest during the next 12 months,” said Frank Nothaft, Freddie Mac’s chief economist.

Thirty-nine percent of homeowners who refinanced were able to reduce their principal balance by paying additional money at the closing table, Freddie Mac reports. Borrowers who were able to refinance using the Home Affordable Refinance Program (HARP) had an average interest rate reduction of 2 percentage points.

“While all borrowers who refinance have benefited, HARP has enabled many borrowers that traditionally would not have had access to refinance to obtain low rates and significantly reduce their interest rate and monthly payment,” Nothaft said. “This increases the likelihood that these borrowers will continue to perform on their loan and remain homeowners.”

If you refinanced to a lower rate in 2012, be sure to check how much money you borrowed when you originally purchased the home. That amount, minus what you have already paid, is your maximum mortgage interest number.