Mortgage-interest deduction can be impacted by multiple refis on primary home

Tom Kelly
Inman News

A friend of mine thought he would take advantage of the rotten winter weather — and the perception that real estate is about the same — and make a low-ball offer on a piece of recreational property that one day could become his second home.

His theory was that owners of summer lake cottages felt removed from their sunny getaways at this time of year and those older owners, reluctant to tackle another stretch of off-season maintenance and security, would especially be more likely to consider a cash proposal during the dark days of winter.

“Besides, I could borrow against my primary residence to pay for most of the place and then take a larger deduction on my income tax.”

While the off-season may be a terrific time to make an offer on a summer cabin, review your debt history on your primary residence if you plan to borrow against it and deduct the mortgage interest on your federal tax return. Under the mortgage-interest guidelines, taxpayers are limited to the original acquisition debt, plus $100,000.

“For owners who have lived in their home a long time and who might have refinanced more than once, the mortgage-interest limit can easily be exceeded,” said Rob Keasal, real estate tax specialist in the accounting firm of Anderson ZurMuehlen & Co. “If you borrow money to make major improvements on your primary residence, that amount is added to your basis. But if you are borrowing to buy another property or pay for college, the limits can be reached in a hurry.”

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.

“Tax deductions differ from tax credits,” Keasal said. “For example, a mortgage-interest deduction, like a charitable deduction, reduces 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.”

For example, let’s say you purchased your primary residence 10 years ago for $100,000 and took out a loan for $80,000 to finance the purchase. Since then, you have paid the loan down to $20,000. The house is now worth $275,000 and you are eyeing a second home. The primary residence definitely has equity to tap, but your mortgage-interest deduction would be limited to the first $120,000 ($20,000 old loan plus $100,000).

According to Keasal, exceeding the limit for the mortgage-interest deduction typically does not spark an Internal Revenue Service audit of an individual’s tax return, especially in a tax year when so many changes were adopted in the last few days of the year.

The IRS recently announced that more than 3 million taxpayers will have to wait until February to get their refunds because of Congress’ late fix to the alternative minimum tax (AMT). The IRS has created a special section on its Web site, www.irs.gov, with updated copies of AMT forms.

“The IRS is looking to question individual returns where the numbers are really out of whack,” Keasal said. “If it has a lot of red flags on one issue — like the home-office deduction once created — it often creates a special form for that issue. If the mortgage-interest deduction comes up during the audit, the taxpayer should be prepared with an answer.”

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 the IRS Publication 527, Residential Rental Property (including Rental of Vacation Homes).

Real estate — including second homes — typically is a sound long-term investment. Yet it’s usually not wise to buy property simply for tax reasons, and borrowing against your home to do so could put your mortgage-interest deduction in questionable territory.

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

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Copyright 2008 Tom Kelly

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