If you feel better knowing you can deduct the mortgage-interest portion of your huge annual housing expenses, make sure you know exactly how much you can deduct.

One of the more popular topics I’ve had with accountants this year is regarding mortgage interest. You can deduct only interest on the original amount of the loan at the time you refinance, plus $100,000. For example, let’s say you purchased your home 10 years ago for $100,000 and took out a loan for $80,000. Since then, you have paid the loan down to $20,000.

The house is now worth $275,000 and your oldest child needs college tuition. The house definitely has equity to tap, but your mortgage interest deduction would be limited to the first $120,000 ($20,000 old loan at the time of “refi,” plus $100,000).

It is important to remember that home-loan-interest deductions simply reduce your taxable income. They are not dollar-for-dollar tax credits that are subtracted from your tax bill. If you have a $1,000-a-month mortgage payment and are in the 15 percent tax bracket, only about $150 a month escapes being taxed in the early months of the loan.

You can deduct the loan fees (“points“) paid to buy or improve your main home in the year of purchase. You cannot deduct these fees in the year you refinanced if you refinanced only to obtain a lower interest rate on your loan.

The term “points,” once used to describe only prepaid interest on government loans, now is used to describe charges paid by a borrower to secure any mortgage. These points can be loan-origination fees or prepaid interest to “buy down” an interest rate. To be deductible, these charges — or points — must represent interest paid for the use of money and must be paid “before the time for which it represents a charge for the use of the money.”

According to the Internal Revenue Service, most points paid when you are refinancing an existing mortgage must be written off over the life of the new loan. However, if you sold a home in 2006, you can still deduct several items, including title insurance costs and excise tax. For guidance on closing costs, the best source may be the settlement sheet from the original loan.

Points on refinance are not fully deductible in the year in which they are paid because they were not paid in connection with the improvement or purchase of a home, even though the original loan met the requirements for deductibility.

What many home sellers forget to factor at tax time are the fees remaining from a previous refinance. All of those fees can be deducted in the tax year you refinanced a second time. For example, let’s say you jumped at a 30-year, fixed-rate loan at 4.5 percent in May 2005. In order to get that lower rate (conventional rates were hovering higher), you had to pay at least 5 discount points. If the loan amount were $80,000, one discount point would amount to $800, and five points would be $4,000.

Points paid to buy, build or improve your principal residence can be deducted in the year they are paid, as long as they were not rolled into the loan amount. However, because you refinanced to simply obtain a lower interest rate, nearly all of the $4,000 must be written off over the life of the loan. That’s because the IRS sees refinancing points as repayment of existing debt.

Let’s say that last month an unexpected need to send Dad into an assisted-living home necessitated another refinance to pull some cash out of the home. You decide on an adjustable-rate mortgage with a very low starting rate and pay no fees. Now that the existing loan is paid off, the remaining balance of the fees from the previous loan is deductible in tax-year 2007.

The tax rules and deductions for second-home owners who rent out their properties on a short-term basis depend on many factors, including how often you personally use your second home, how many nights or a percentage of the nights you rent out your home, and your personal adjusted gross income (AGI). The details can be found in IRS Publication 527, Residential Rental Property (including Rental of Vacation Homes).

Now, I need to do a better job of recording all of my deductible expenses that often slip through the cracks. It seems I might have to counter the loss of some mortgage interest for 2007.

To get even more valuable advice from Tom, visit his Second Home Center.

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