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Avoid tax confusion after refi

By Inman News Feed
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Avoid tax confusion after refi

Tom Kelly
Inman News

I have a friend who has worked the upscale second-home market in and around Vail, Colo., for years. He's seen people pay astronomical prices when values were on the uptick, and watched others gather bargains from folks desperate to sell when residential property headed downhill.

Earlier this year, he had a customer who refinanced a primary residence and took out a significant amount of money to help with the downpayment on a second home. While this is done all the time, part of his justification for doing so was the mammoth mortgage interest deductions he would receive on both homes.

Buyers need to be aware of the mortgage interest ceilings, especially heading into the April 15 tax deadline. According to the Internal Revenue Service, taxpayers may deduct interest on no more than a combined total of $1 million of "home acquisition debt" for a primary home and secondary residence. (The limit is reduced to $500,000 if you are married and filing separately. See Internal Revenue Service Publication 936 for details.)

Home acquisition debt means any loan used to acquire, to construct, or substantially to improve a qualified home.

Taxpayers may also deduct up to a combined total of $100,000 of home equity debt on their first and second homes. Home equity debt is defined as a loan whose purpose is not to acquire, to construct, or substantially to improve a qualified home, or any loan whose purposes was to substantially improve a qualified home but exceeds the home acquisition debt limit.

For example, let's say the customer paid $1.3 million for the Vail getaway and took out a mortgage for $800,000. If he has a $200,000 mortgage on his primary residence, he has reached his acquisition debt maximum deduction for both homes. He is also entitled to deduct an additional combined total of $100,000 in home equity debt on both homes.

Taxpayers often are confused by the amount of mortgage interest they can deduct after they refinance. If you did refinance last year, double-check your numbers. You can only deduct interest on the original amount of the loan at the time you refinance, plus $100,000.

For example, let's say you purchased your home 10 years ago for $100,000 and took out a loan for $80,000. Since then, you have paid the loan down to $20,000.

The house is now worth $275,000 and you want to be a second home in Vail. The house definitely has equity to tap, but your mortgage interest deduction would be limited to the first $120,000 ($20,000 old loan at the time of refi, plus $100,000).

It is important to remember that home-loan-interest deductions simply reduce your taxable income. They are not dollar-for-dollar tax credits that are subtracted from your tax bill. If you have a $1,000 a month mortgage payment and are in the 15 percent tax bracket, only about $150 a month escapes being taxed in the early months of the loan. 

You can deduct the loan fees ("points") paid to buy or improve your main home in the year of purchase. You cannot deduct these fees in the year you refinanced if you refinanced only to obtain a lower interest rate on your loan. 

The term "points," once used to describe only prepaid interest on government loans, now is used to describe charges paid by a borrower to secure any mortgage. These points can be loan origination fees or prepaid interest to "buy down" an interest rate.

To be deductible, these charges -- or points -- must represent interest paid for the use of money and must be paid "before the time for which it represents a charge for the use of the money." 

According to the IRS, most points paid when you are refinancing an existing mortgage must be written off over the life of the new loan. However, if you sold a home in 2009 you can still deduct several items, including title insurance costs and excise tax. For guidance on closing costs, the best source may be the settlement sheet from the original loan.

Tom Kelly's book "Cashing In on a Second Home in Mexico: How to Buy, Rent and Profit from Property South of the Border" was written with Mitch Creekmore, senior vice president of Houston-based Stewart International. The book is available in retail stores, on Amazon.com and on tomkelly.com.

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