Are you paying too much interest on your home mortgage? Only you can be the judge of that – but right now, interest rates are at an all-time low. You may want to consider refinancing your existing home mortgage to take advantage of these super low rates. Especially if doing substantially reduces your monthly mortgage payments. Some lenders are offering rates as low as 2.75%.
Acquisition Debt versus Equity Debt
If you are thinking about refinancing your current home loan, consider the tax ramifications before making your decision. The 2018 tax reform made changes that may impact your taxes. Home mortgage debt can consist of acquisition debt and equity debt. Acquisition debt is the debt incurred when you purchase your home or make substantial improvements. Equity debt is debt secured by the home that you use for other purposes not related to buying your home.
Home Equity Debt – No Longer Deductible
Prior to 2018, homeowners could deduct the interest paid (up to $100,000 of equity debt) as an itemized deduction. However, with the passage of tax reform, the interest on home equity debt is no longer deductible. So, if you are considering refinancing for more than the current balance of your acquisition debt and won’t be spending the extra amount to make substantial improvements to your home, keep in mind that the interest you’ll pay on the refinanced debt may only be deductible on the portion of the loan that represents acquisition debt. Be aware so that you don’t end up paying too much interest.
There are other tax pitfalls as well. Prior to tax reform, acquisition debt could be refinanced for a longer term. Also the interest would continue to be tax deductible for the term of the refinanced loan. Under tax reform, that is no longer the case.
Example: Your original acquisition debt loan was for 30 years. After 20 years, you refinance the original loan into a 15-year loan. Because the refinanced debt extends the overall combined term of the acquisition debt by 5 years, the interest on the debt is only deductible for the subsequent 10 years. In addition, if any of the refinanced debt was equity debt, the refinanced debt must be allocated between the two. That is the acquisition debt and equity debt are considered differently. Now, only the interest on the acquisition portion being tax deductible.
Of course, if the additional refinanced debt was used to make a substantial home improvement that changes the rules. For example if you:
- added solar power
- remodeled the kitchen
- added a room
that portion of the refinanced debt will be acquisition debt and the interest will be deductible.
Acquisition Debt Limits
One more potential tax trap related to refinancing is that tax reform reduced the maximum amount of acquisition debt. It used to be that the interest was deductible from $1 million to $750,000. This was for a taxpayer’s first and second homes. The $1 million debt cap was grandfathered for acquisition debt loans in effect prior to tax reform, and those can still be refinanced for their current balance without being subject to the $750,000 limit. However, if a grandfathered loan is refinanced for more than the current balance of the loan, the new $750,000 acquisition debt limit could come into play. And you could end up paying a different amount of interest than you expect.
Example: You purchased a home before tax reform, and the initial acquisition loan balance was $850,000. The current balance on the loan is $800,000. You refinance it for the same amount to get a lower interest rate. Under these circumstances, the interest on the entire $800,000 refinanced loan continues to be tax deductible as home acquisition debt interest. This is because it was a grandfathered debt.
Example: Same as above with the exception that follows:
The original acquisition loan balance has been paid down to a current balance of $700,000. You refinance the loan for $800,000, using the additional $100,000 to add a room to the home. Because the additional $100,000 is not grandfathered debt, the $750,000 acquisition debt limit comes into play. Now only interest you pay on, up to $750,000 of the refinanced debt, is deductible.
To Itemize, or Not to Itemize – That is The Question
In these examples, we talk about the interest being deductible. But you can only claim the mortgage interest as a tax deduction if you itemize your deductions. Another aspect of tax reform was the approximate doubling of the standard deduction amount. As a result, many taxpayers who itemized prior to tax reform now find that the standard deduction gives them a greater deduction. Some who refinance for a lower interest rate (and, lower interest payments) may find that their total itemized deductions will now be less than the standard deduction. This means that they won’t have any tax benefit from their home.
Putting these tax limitations aside, it still may be financially beneficial to refinance. Refinancing reduces interest and monthly payments without increasing the amount of the loan. Owning your home debt-free by the time you reach retirement is an important goal. Thus, you should do everything in your power to avoid using the equity in your home and prolonging the payments. However, there may be times when using that equity becomes necessary. For example, paying off high-interest credit card debt or paying for junior’s college education.
You can use our “Should I Refinace My Mortgage?” calculator to compare your current mortgage payment with a refinanced mortgage payment based upon interest rates and loan term.
Combining tax considerations and refinancing options can become quite complicated. If you need assistance in making a refinancing decision, please give this office a call at (360) 778-2901.
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