With mortgage rates hitting record lows, some homeowners may be looking to refinance their mortgage for the first time since new federal tax rules took effect after Congress passed the Tax Cuts and Jobs Act in December 2017.
The rules are fairly straightforward for new mortgages taken out after Dec. 15, 2017. But when it comes to refinancing a loan taken out before that date — I’ll call it a grandfathered loan — they get a little tricky.
Before the law changed, you could deduct interest on a total of $1 million in debt used to buy or substantially improve one or two personal residences. In addition, you could deduct interest on up to $100,000 of debt secured by your home that was used for any other purpose, such as buying a car or paying off credit cards.
The law made two major changes.
For new mortgages taken out after Dec. 15, 2017, you can only deduct interest on up to $750,000 in debt used to buy or substantially improve up to two homes. For grandfathered loans, the old $1 million limit still applies. (The limits are half that for married couples filing separately.)
The law also eliminated the ability to deduct interest on any type of mortgage debt that was not used to buy or improve a home, even if the debt was taken out before Dec. 16, 2017. In other words, it applied retroactively and prospectively. This applies to home equity loans and lines of credit. And if you refinanced a loan for more than the outstanding balance (called a cash-out refi) and used the extra cash for something other than buying or improving a home, interest on the cash-out portion is no longer deductible.
What happens if you refinance a grandfathered mortgage? Suppose your original debt was $1 million, and the remaining balance is $850,000.
As long as you refinance no more than the remaining balance, $850,000 in this example, your loan remains grandfathered and you can deduct interest on the full amount.
What if you refinance more than the balance, say $900,000?
In this case you can still deduct interest on up to $850,000, but you cannot deduct interest on the extra $50,000, no matter how it is used, said Keith Gumbinger, a vice president with mortgage website.
If your remaining balance is below $750,000 — say $700,000 — and you take out $45,000 in cash to substantially improve your home, you can deduct interest on up to $745,000 because it’s still below the new limit. If you used the $45,000 for anything else, you can only deduct interest on $700,000 max.
The IRS considers an improvement substantial if it adds to your home’s value, prolongs its useful life or adapts it to new uses.
Bear in mind that your lender doesn’t know how you use the money. It will send you, and the IRS, a 1098 form showing how much interest you paid. It’s up to you to keep records showing how the loan proceeds were used in case you get audited.
Also remember that California has not conformed to these changes in the federal law, so for state taxes, the old rules still apply.
Another thing to consider no matter how big your mortgage: The federal tax law roughly doubled the standard deduction. For 2020, it’s $24,800 for married couples filing jointly, $12,400 for single and married filing separately and $18,650 for heads of household. (It’s slightly higher if you’re 65 or older.)
If you had been itemizing deductions, refinancing could lower your interest deduction to the point where you would be taking the standard deduction instead, said Mark Luscombe, principal analyst with Wolters Kluwer Tax & Accounting,
In that case, you would no longer get the benefit of other itemized deductions, such as charitable contributions and state and local taxes. Remember, though, that the deduction for all state and local taxes — including income and property taxes — combined is now $10,000. If you work and own a home in the Bay Area, you could be above that limit.
Depending on your situation, the money you save on your mortgage could outweigh any tax savings you lose by switching to the standard deduction, Luscombe said.
He added that a loan can only remain grandfathered until the end date of the original mortgage you took out when you first bought the home. If you bought a home with a 30-year mortgage in 2010, refinanced it in 2015, and again in 2020, you can only deduct interest on up to $1 million until 2040, the end date of the original mortgage.
You may have to pay a loan origination fee, also known as points, on your loan. One point is 1% of the loan amount. When you pay points on a new mortgage, they are fully deductible the year you pay them. Any points you pay to refinance a loan can only be deducted over the life of the loan. (This did not change under the 2017 law.)