With home mortgage interest rates at historic lows, many homeowners are seeking to refinance their mortgages. If you are planning to refinance, knowing the interest deduction rules and how they apply to your property may help you maximize your tax savings.

Interest deduction

If the old mortgage is paid off, but no additional cash is received by the homeowner, all of the interest payments on the new loan are tax deductible up to a loan limit of $1 million.

The rules differ if the new mortgage is larger than the original mortgage — that is, the homeowner refinances the old loan and also obtains additional cash. That portion of the new loan that is used to replace the original loan is treated the same as the original loan — the interest paid on the amount is fully deductible.

Tax treatment of the portion of the new loan used to obtain cash depends on what the cash is used for. If the cash is used to improve or remodel the house, the interest is fully deductible.

However, if the cash is used for some other purposes — for example, to pay for a child’s college education or medical bills — the interest is deductible only up to a loan amount of $100,000.

Deducting points

Points paid to obtain a refinanced mortgage must be deducted over the life of the loan. To figure the annual deduction amount, divide the total points paid by the number of payments to be made over the life of the loan.

Usually, this information is available from the lender. For example, a homeowner who paid $2,000 in points on a 30-year mortgage (360 monthly payments) could deduct $5.56 per payment, or a total of $66.72 for 12 payments. Taxpayers may deduct points only for those payments actually made in the tax year.

A homeowner who uses part of the refinanced mortgage money to pay for improvements to the home, and meets certain other requirements, may generally deduct the points associated with the home improvements in the year paid, spreading out the rest of the points over the life of the loan.

When refinancing for a second time, or paying off a loan early, a homeowner may deduct all the not-yet-deducted points from the first refinancing when that loan is paid off.

Closing costs

Other closing costs, such as appraisal fees and processing fees, generally are not deductible.

Prepayment penalties

Some loans contain a clause that charges a penalty if the mortgage is paid off early. This penalty is generally deductible as a mortgage-interest expense in the year that it is paid.

Internal Revenue Service Publication 936: Home Mortgage Interest Deduction has more details on deductions related to refinancing.

Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.

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