Tax Breaks for Refinancing Mortgages

Definition

Refinancing your mortgage involves securing another mortgage loan to repay fully your first loan. Mortgage owners typically refinance to pay a lower interest rate. If you've significantly reduced your first loan's balance, you may claim some or all of your equity as a cash loan when you refinance. The balance that you paid since your first mortgage has become equity that you own, so you may use that equity as collateral for a loan. What you do with the loan determines your eligibility for a full tax reduction on loan interest.

Interest paid on your new mortgage's balance is tax-deductible. The interest paid on any cash loan accompanying your refinanced mortgage is tax-deductible if you apply the loan toward significantly improving your home. For example, if you pay down a $300,000 mortgage to $150,000 and take out an accompanying $100,000 loan based on your home's current $350,000 value, then you may subtract interest accrued on the full $250,000 if you spent the $100,000 loan on remodeling your kitchen and building an additional bedroom. If you spent $30,000 of the $100,000 loan on a vacation and credit card debt instead, then you cannot subtract the interest paid on the $30,000.

Refinancing multiple times with different lenders gives you the opportunity to make a large one-time tax reduction on points paid. A point is 1 percent of your loan. Points that homeowners offer as down payment for refinancing are tax-deductible, but homeowners refinancing for the first time must divide the reduction equally over the life of the loan. If you refinance your mortgage again, with a different lender, you may deduct the remaining divided points in the year you refinance. For example, if you pay three points to refinance a $250,000 mortgage balance (which is $7,500), and your new refinanced mortgage is for 20 years, the $7,500 is divided equally into a $375 reduction each year. Refinancing again after two years allows you to reduce your taxes by the remaining unclaimed points ($6,750).

You may deduct home mortgage interest, interest paid on equity loans to improve your home and points on Schedule A of Form 1040. Your lender will send you Form 1098 to report all the mortgage interest you paid. You must itemize deductions in order to claim these tax breaks.