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| The Basics | The IRS is happy you refinanced, too
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Yes, refinancing your mortgage cuts the monthly payment. But the IRS is a winner from your savings, too. Your smaller mortgage deduction means you could get a bigger tax bill.
By Jeff Schnepper
The great mortgage refinancing boom may have peaked, but, when we can, we're only too happy to refinance. In fact, the Mortgage Bankers Association of America projects that American families will still refinance $1.14 trillion of mortgages in 2005 and another $861 billion in 2006.
Heres the good news for 2005: All that refinancing will save some $5 billion to $6 billion in interest payments and free up roughly $4 billion or so for us to spend. Refinancings have been a huge reason that consumer spending has been so strong in the last few years.
But theres a catch: Those of us who refinanced will also pay close to $1.6 billion in additional federal income taxes.
The tax hit won't affect everyone. It only affects you if you itemize your deductions. That's the price for refinancing.
If you don't itemize
If you don't itemize, the rest of this just doesn't apply to you. Put a big smile on your standard deduction face.
You've now locked into some of the lowest interest rates in 30 years, and the difference between the rates is stuffing your pockets with dollars that would have gone to your mortgage company. Alternatively, you could pay the same amount of dollars out of pocket and pay off your home in fewer years.
In any case, you're the big winner!
If you do itemize
This is what happens when you itemize: If you pay less, you deduct less. If you refinanced a $100,000 loan from 9% to 6%, that's a 3 percentage point difference, or roughly $3,000 that you don't get to deduct.
The earlier in the year you refinanced, the more of that $3,000 you're going to lose. Over the 12 months of 2006, you're going to lose the whole difference.
(I know that the principal is reduced with each payment, so my numbers are off.)
But you're still way ahead, no matter how much you lose. With a top federal tax bracket of 35% in 2005 and 2006, a loss of $3,000 in interest deductions costs you $1,050. But you didn't pay $3,000. So you're still $1,950 ahead.
And clearly you put aside at least enough cash out of the $3,000 saved to pay the additional tax -- right?
Do you really need to itemize?
The reduction in your interest deduction may have other consequences you should consider before the end of the year.
For most of us, you itemize only if your itemized deductions exceed your standard deduction. For 2005, the standard deduction is $5,000 for a single and $10,000 for couples filing jointly.
The reduced deduction may put you below these numbers. In that case, you should take the standard deduction instead.
But what about the points?
There may be some sunshine behind the cloud. Unlike when you buy your house, when you refinance, any points you pay are normally amortized on a monthly basis over the life of the loan.
So, say you refinanced a $100,000 loan for 20 years at a cost of three points, or 3%. That $3,000 would be divided by the loan term, 240 months, for a $12.50-per-month deduction. If you took out the loan on July 1, 2005, you'd have six months of amortization, or a deduction of $75. In 2006, you'd take a full year's deduction of $150.
That's the bad news: You can't just deduct all the points right away.
The good news: There's an exception. Let's say you refinanced your mortgage for more than your original loan and used the difference to improve your home. Then the percentage of points paid representing the dollars used for the improvement can be deducted in the first year.
Now, your home has substantially appreciated in value. In 2005, you're able to borrow $300,000 to refinance a $200,000 loan. You put $100,000 into improvements to your property. If you paid $3,000 in points, one third or $1,000 (representing $100,000/$300,000) would be an allowable deduction in 2005.
You'd also get to deduct the additional $2,000 paid, over the term of the loan. Over 240 months, that would give you an additional deduction of $8.33 per month.
The break from multiple refinancings
Here's more good news. If this isn't your first refinancing, you'll probably have what the tax pros call "unamortized points." Those are the points that you paid on your first refinancing that haven't been allowed yet.
Those points are allowed IN FULL in the year you refinance.
So, let's say you refinanced on July 1, 2004, and again on July 1, 2005. On the first refinance, you paid $3,000 in points for a 30-year note. Last year, you deducted six months' worth of amortization, or $50 (That's $3,000 divided by 360 months, multiplied by six months).
This year you get to deduct the remaining $2,950 in full.
What else can you do to make up this year's loss?
Make your Jan. 1, 2006, mortgage payment on Dec. 31. The payment is for the use of the money in December, and you can deduct the mortgage interest on your 2005 return.
Your mortgage company won't receive it until 2006, so the interest won't be shown on their Form 1098. Remember to run an amortization schedule and add the additional 2005 interest payment on line 11 of your Schedule A.
Run your own numbers. Make sure that you meet the safe harbors for withholdings and estimated payments.
Bottom line: Unless you're in a tax bracket that's over 100%, a reduction in interest rates is going to save you real cash money -- even after the tax loss. So don't worry about the taxes. Just plan for them.
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