The 2017 TCJA amended many rules relating to mortgage deductions and refinancing. Understanding the new tax laws can help you reduce your tax burden after refinancing. We'll discuss some of the deductions you can claim on your federal taxes after refinancing and how long you can claim them.
Some Tax Deduction Rules
A deduction is an expense that can reduce your tax burden, reducing the total amount you are taxed when you make a deduction. For example, if you earn $ 45,000 a year before tax and have a deduction of $ 5,000, you will only pay taxes on $ 40,000 of your income.
New tax laws have improved the standard deduction for single and married taxpayers. However, many of the deductions homeowners might claim earlier are no longer available or are less significant than before. For example, the TCJA provides limited interest deductions on most home loans. It also eliminated the insurance deduction on most home loans. Let us look at some specific deductions you can take advantage of during the refinancing year and beyond.
One of the first questions most homeowners ask themselves when considering refinancing is the type of income rules that apply to refinancing taxes. When you accept a refinance fee, you accept a higher principal loan, and your lender makes the cash difference. But is this money considered income? Do you have to declare it on your return?
The IRS does not treat cash from a cash-out refinance as income. Instead, they see it as debt restructuring. This means that you don't have to report the money withdrawn from your home equity as income.
What can you deduct from income tax?
Let's take a look at some expenses you can deduct after refinancing.
Mortgage interest
The most important deduction you are normally entitled to is the mortgage interest deduction on the original loan and refinance. However, special rules apply to the deduction of interest on a cash-out refinance.
First, let's talk about mortgage interest rates at a standard rate and term refinance. You can deduct the interest paid on the refinanced loan if all of the following conditions are met:
The lender who finances your home has a lien on your property. This means that if you are behind on your payments, the lender can confiscate your property or put the loan into foreclosure.
The loan is for the primary residence or second home that you do not rent out.
You itemize your income tax return.
The rules are slightly different if you go for cash-out refinance. You can deduct interest on the original loan balance regardless of how much equity you take out on your home, but you can only do so if you use that money to improve your home.
A capital improvement is any lasting addition you make to the home that increases its value. Here are some examples of major home improvements:
Adding a pool, spa, or hot tub to your backyard.
Building a home office or adding another room to the home
Installation of a garage door with a remote control where there was previously a manual door
Roof replacement
Improvements in equity don't have to be costly. Here are some examples of low-capitalization residential improvements:
Adding a home security system
Installation of the central heating and cooling system
Replacement of windows with shutters
Remember that only permanent additions or renovations are considered major home improvements. Cosmetic repairs and modifications (such as painting a room) do not count towards your property's total value. This means that you can't deduct anything if you use the money to do home repairs or minor design changes. You also cannot deduct refinancing interest from your cash-out refinance if you use the money for other purposes, such as paying off credit card debt or going on vacations.
Let's look at an illustration to illustrate this point. Suppose you have a mortgage with a principal amount of $ 50,000. You know you want to get $ 15,000 on your principal by refinancing, but you have no idea what to spend it on. You have two options: you can add a natatorium to your backyard, or you can pay off your credit card debt.
The swimming pool is a great improvement for your home. This means that you can deduct any interest on the total loan balance, which is $65,000 after refinancing. However, you can pay off your credit card debt, but you can only deduct interest from your original balance of $50,000.
Discount points
You may be able to purchase discount points when you close on your loan. Discount points reduce the interest rate. Each point costs 1% of the total loan amount. For instance, if you refinance a loan with a principal amount of $100,000, each point will cost $1,000. You might hear a lender talk about "buying down" your interest rate.
Discount points are fully deductible, despite the type of property you are refinancing. You can also subtract discount points on regular refinances and withdrawals.
Closing cost on a rental property
It is not possible to deduct settlement costs and other closing costs on a primary or secondary residence. However, different rules apply to rental properties. The IRS considers money earned from renting a house or condo to be taxable income.
You have a lot more freedom when you deduct closing costs and other maintenance costs to refinance a rental property. Some expenses you can claim as a rental property deduction include:
Appraisal fees
Inspection fees requested by the State
Lawyers' fees
Legal and registration fees
Refinancing application fees
Also, you can deduct insurance and repair costs related to a rental property.
How long after refinancing can I claim a tax deduction?
You can deduct most of the closing costs when refinancing. This implies that if you refinance your mortgage for 15 years, you must allocate the deductions on your 15-year tax return. Let's see how it works in practice.
Mortgage interest
You can deduct the interest paid on the refinanced loan as long as it meets the criteria set out above. You can claim a deduction each year when you make loan payments. However, you can only deduct the interest paid in that year. For example, you can pay $ 1,000 for your home loan in your fiscal year 2020, but you can only deduct $ 1,000 in taxes. This means that as the loan nears maturity, you will be able to claim fewer and fewer interest deductions as more and more payments go into the principal.
Don't know how much you paid in interest this year? The mortgage lender will send you a Form 1098 at the start of each new fiscal year. This is your mortgage statement and shows exactly how much interest you paid. You do not need to include a copy of Form 1098 with your tax return, but the creditor is responsible for filing a copy with the IRS. If you do not receive a Form 1098 by email or have questions about your statement balance, please contact your creditor.
Discount points and closing costs
It is impossible to deduct the full amount paid at the end of the year that you are refinancing if you purchase discount points. Instead, you need to spread the deductions throughout the loan. For example, suppose you paid $5,000 when the discount points closed. Suppose your refinanced loan is ten years away. You will only be able to deduct $ 500 per year from federal taxes. However, you can claim this deduction each year until the loan matures.
The same rules apply to the closing costs of refinancing a rental property. For example, if you spent $15,000 closing costs for a 15-year refinance, you would deduct $ 1,000 per year until the loan matures.
Restrictions on mortgage tax deductions
Please note that most deductions only apply to owners who itemize their deductions. This involves adding up all the individual deductions you are entitled to and deducting them from your taxable income. You can choose to itemize the deductions or take the standard deduction. The standard deduction is a one-time deduction that anyone can claim without asking questions. The standard deductions for 2020 are as follows:
$ 12,400 for individual and married filing jointly
$ 18,650 for Head of Households
$ 24,800 for married filing jointly
The standard deductions for 2021 are as follows:
$ 12,550 for singles, married filing separately
$ 25,100 for married filing jointly
You cannot deduct items like interest and mortgage points if you make the standard deduction. This rule applies to both the refinancing of primary residences and the deductions from real estate investments.
Summary
A deduction is a subtraction you can claim on your federal taxes, which reduces your tax burden. There are numerous tax deductions you can take advantage of when refinancing a home loan. You could deduct the full amount of interest paid on your loan last year if you did a standard refinance at a primary or secondary residence. You can only deduct 100% of the interest if you agree to a refinancing fee, especially if you are using the money to improve your assets. Otherwise, you can only deduct the interest rate paid on the original loan balance.
You can also deduct the discount points and closing costs you pay to refinance a real estate investment. You should spread these costs over the entire refinancing period and deduct them only by itemizing the deductions.
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