With home mortgage rates with adjustable rate and higher interest fixed rate mortgages may be motivated to refinance now. Here’s a review of the tax angles clients should be aware when they consider refinancing their home loans.

Deductions from existing the old mortgage.

Prepayment penalties are deductible as interest subject to the rules of Code Sec. 163. (Rev Rul 57-198, 1957-CB 94) Thus, if there’s a penalty for paying off a mortgage early, it’s fully deductible if the retired debt itself qualified as acquisition debt or home-equity debt under Code Sec. 163(h)(3). Additionally, if the borrower had to deduct points over the life of the old mortgage, the remaining, unamortized portion of the points charge may be deducted currently as interest (again, assuming the underlying loan qualified). (IRS Letter Ruling 8637058 IRS Pub. No. 936 (2000) p.6)

Illustration: Several years ago, Jackson refinanced his home mortgage loan and used the proceeds to pay off in full his original home mortgage. His refinancing mortgage (loan #2) was a 30-year fixed rate loan for $100,000; Jackson paid three points ($3,000) on the refinancing. Because all of the loan proceeds were used to pay off the original mortgage and none were used to purchase or improve his principal residence, all of the points on the refinancing loan had to be amortized over its term (see discussion below). This year, Jackson refinances with a lower-interest mortgage (loan #3) when there’s a remaining unamortized points balance of $2,400 on loan #2. Jackson can deduct the $2,400 as home mortgage interest on his 2001 return.

Points on the new loan. If the conditions of Code Sec. 461 (g)(2) are satisfied, points paid in connection with the purchase or improvement of a principal residence are currently deductible. IRS says that points paid on a refinance loan are deductible.

(1) only if the borrower pays the charge out of his own cash at the closing (e.g., the charge isn’t withheld from 4-1 the mortgage loan), and (2) only to the extent the proceeds are used to improve the residence. (Rev Rul 87-22, 1987-1 CB 146; Rev Proc 9212, Sec. 4.04, 1992-1 CB 662)

The currently deductible amount is based on the ratio of borrowed funds used for improvement to the total amount of the loan. (Rev Rul 87-22, 1987-1 CB 146)

The Eighth Circuit has ruled that a taxpayer who financed the purchase of a residence with a three-year mortgage loan and then refinanced in the third year, could currently deduct the points on the refinance loan. (Huntsman, James, (1990, CA8), 905 F2d 1182, 66 AFTR 2d 90-5020 revg & remdg (1988) 91 TC 917) However, IRS won’t follow Huntsman outside of the Eight Circuit, (Action on Decision 1991-02, 2/11/91) And the Tax Court has said that the Eight Circuit’s rule does not apply where the original loan was a 30-year loan and the purpose of the refinancing was to obtain a lower interest rate and a fixed rather than variable interest rate. (Kelly, David, (1991) TC Memo 191605,62 CCHTCM 1406, TC Memo 1991-605)

How to handle points that can’t be claimed currently. If points aren’t currently deductible under Code Sec. 461 (,g)(2), they generally must be deducted over the life of the loan using OID-type economic accrual principles. However, IRS says a borrower can find the amount deductible annually by:

… dividing the non-currently-deductible points charge by the number of monthly payments to be made on the loan, then

…multiplying the result by the number of mortgage payments made during the tax year.

This expedient is available only if the points are paid in connection with a loan of not more than $250,000 that: