Lower mortgage interest rates are good news for homeowners who are seeking to refinance and for those who are looking to purchase a home. Lower rates add flexibility to the negotiation of loan terms, mortgage interest, points, financed amount, and term of the loan. But refinancing an existing mortgage can raise your taxes, too.
Typically, in a refinance, you pay a lower rate of interest, and you pay less interest over the remaining course of the loan. While this is desirable, lower mortgage payments will likely also result in a lower mortgage-interest tax deduction:
Reduction in mortgage interest (and tax deduction): $6,000 Federal tax rate: 28% State tax rate (Maryland): 8% Total tax rate 36%
Multiply total tax rate times the reduction to mortgage
interest: 36% x $6,000 = $2,160 tax increase
Total savings from refinance: $6,000 – $2,160 = $3,840
You still come out way ahead, but be prepared in your 2011 tax return to cover the additional taxes.
Watch Out: Sometimes, Mortgage Interest Is Not Tax Deductible
There is another aspect to the tax deduction for mortgage interest that you’ll want to consider: how the IRS classifies mortgage interest. The IRS categorizes mortgage interest into acquisition indebtedness and home-equity indebtedness. Home acquisition indebtedness is defined as a mortgage to purchase, construct, and/or improve your home. Home-equity indebtedness is defined as any other debt (secured by your home) not used as acquisition indebtedness.
Tax deductions on each type of interest have upper limits. For acquisitions, it’s $1 million. For home-equity, it’s $100,000.
Assume that you refinance and take extra cash (equity) out of your home.
Current mortgage balance is $200,000.
Refinance and borrow $320,000 (extra cash for home renovations and down payment on vacation property).
Based on IRS rules, $200,000 of the $300,000 is classified as acquisition indebtedness (it replaces the balance on the original loan). The interest on the remaining $120,000 is classified as home-equity indebtedness. The interest on the first $100,000 of home-equity indebtedness is fully deductible as mortgage interest. But the other $20,000 would be deductible only under certain circumstances related to the use of that money.
You may need to plan for this change to your taxes. You can increase tax withholding from your salary, or make quarterly payments. BWFA can help you with this calculation; please call our tax department at 410-461-3900.