Debits & Credits
by Douglas Schultz & Alex Yarmolinsky
Q. With interest rates still at historical lows, what tax rules should be considered before and after refinancing?
A. Tax implications related to the deductibility of mortgage interest, points and costs paid, and prepayment of a loan all surround the decision about refinancing. Knowing the rules may help you make your next refinancing decision. The following is an overview of the basic rules in these areas for both rental properties and personal residences.
Types of Refinancing
The existing mortgage is paid off with proceeds from a new mortgage, but no cash is received by the borrower in the transaction. This is done generally for the purpose of lowering the interest rate or improving other terms of the existing loan.
The new mortgage amount is higher than the principal balance of the existing mortgage. This provides the property owner with additional cash upon close of the refinance. The deductibility of the interest on the additional loan amount is discussed below.
This is an additional loan (also secured by the property) and has no impact on the original mortgage. There are generally no closing costs paid in association with opening a line of credit.
Some loans contain a clause that charges a penalty if the mortgage is paid off in advance. This penalty is generally deductible as a mortgage-interest expense in the year that it is paid, both for rental properties and personal residences.
Points Paid on Refinance
The term known as points is used to describe certain charges the borrower pays to obtain a mortgage. Points may also be called loan origination fees, loan discounts or discount points. These points are calculated as a percentage of the loan amount and are generally included on the closing statement for the refinance transaction.
While points paid on the initial purchase of a primary residence are generally deductible in the year paid, points paid to refinance an existing mortgage on either a residence or a rental property are generally not deductible in full in the year paid. Instead, the points paid are deducted ratably over the life of the loan as an amortization expense. For example, if $1,000 was paid as a loan origination fee on the refinance of your personal residence, and the new loan is for 30 years, the annual amount of amortization expense would be $33, starting in the month the refinance closed. The remaining points may be deducted in full at the time the loan is refinanced again or the loan is paid off (either due to early payoff or sale). For a rental property, amortization expense is reported with the other operating expenses on Schedule E. For a primary residence, the amortization expense is included as an itemized deduction on Schedule A.
Closing Costs Paid on Refinance
Closing costs on refinancing include mortgage commissions, abstract fees, recording fees and any other related fees that are associated with the refinancing of the mortgage. These will also be included on the closing statement for the refinance transaction.
For rental properties, these closing costs are treated as capital expenditures and amortized over the life of the loan along with any points, as discussed above. As with points, these costs would be deducted in full at the time the loan is refinanced again or the loan is paid off. For personal residences, these costs are not deductible as expenses.
When cash is received from a refinance, the deductibility of the interest on the underlying loan depends on the way those proceeds are used. This loan- and interest-allocation process is known as interest tracing, and it is essential to computing interest deductions each tax year.
For rental properties, all proceeds received in a refinance must be traced in order to determine the deductibility of interest. The loan proceeds should be categorized according to the following types (in an order from best to worst tax treatment): (1) trade or business, (2) investment or portfolio, and (3) personal. The interest deduction will depend on which of these categories the proceeds were used. For example, if the proceeds were used to invest in the taxpayer’s business, the interest on those loan proceeds would be considered a business expense for that business. If the proceeds were reinvested in the existing rental property by making improvements, the interest deduction would remain with the property and be deducted in the same manner as the original mortgage. If the refinance proceeds were invested in a new rental property, the related interest expense would be deducted against the income on that new property. If the proceeds were used for personal use (to pay for a vacation or children’s education expenses), the interest on those proceeds would be nondeductible. As a tax-planning strategy, any principal payments against a refinanced loan should be applied in the reverse order of the above-mentioned types—first to personal interest and then finally to trade or business interest. Typically, rental properties are subject to the passive-activity loss limitation rules.
Generally, the proceeds used to pay off the existing mortgage will maintain the same character as the original loan. For example, if the existing mortgage is secured by the property and was originally taken out to purchase the property, the debt (and the refinance proceeds used to pay off the original debt) will be considered acquisition indebtedness, and the interest on that debt is deductible.
Personal residences are treated slightly differently, in that there are limitations to the amount of loan on which interest is deductible. All loans must be secured by the personal residence to qualify for an interest deduction. Debt on a personal residence is classified in two parts: (1) acquisition indebtedness on debt incurred to purchase a property (deductible up to a loan balance of $1,000,000), and (2) home equity indebtedness incurred for any purpose (deductible up to a loan balance of $100,000). Interest on loan amounts within these limits is fully deductible for regular tax purposes. If the home equity indebtedness is incurred for a reason other than improving or remodeling the house, this portion of interest is not deductible for alternative minimum tax purposes (see your tax advisor to determine if this affects your tax situation).
If you are planning to refinance, knowing the interest deduction rules and how they apply to your property may help you maximize your tax savings.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinsky is a CPA and a manager in the tax practice at Burr, Pilger and Mayer. Copyright © 2004 by the San Francisco Apartment Magazine. All rights reserved.