Refinancing your home can help you save money, change your loan term, or cash out some of the equity you’ve built up.

With real estate experts predicting the Federal Reserve will lower rates through the end of the year and into next year, it might feel like the perfect time to strike. But before you apply to replace your existing home loan, there’s an important aspect of mortgage interest you can’t afford to overlook: taxes.

Yeah, we know it’s not exciting, but understanding the tax implications of refinancing could save you from unpleasant surprises when tax season rolls around.

What is refinancing and how does it affect your taxes?

Refinancing means taking out a new mortgage to replace your current one—often at a lower interest rate or with more favorable terms. Sounds pretty good, right? While refinancing can lead to lower monthly payments and save you money in the long run, it can also impact your tax deductions.

Mortgage interest deduction

First, let’s talk about a tax break that homeowners love: the mortgage interest deduction.

The mortgage interest deduction lets you subtract the interest you pay on your mortgage loan, but there are a few rules and limitations to keep in mind:

• You can only claim the deduction for your primary residence and one vacation or second home. So, if you’re dreaming of that third vacation house, the IRS doesn’t quite share your enthusiasm.
• You’re limited to interest paid on loans up to $750,000 ($375,000 if you’re married filing separately from your spouse).
• To use this tax break, you need to itemize deductions rather than claiming the standard deduction.
• You can only claim mortgage interest paid on home acquisition debt. This means you used the loan proceeds to buy, build, or substantially improve the home securing the loan.

That last bullet point is where refinancing comes into play.

You can deduct the full amount of interest you paid on your loan if you do a standard refinance on your primary or secondary residence. But the rules are a little different if you opt for a cash-out refinance.

In a cash-out refinance, you refinance into a bigger mortgage loan and take some of your equity out. Whether you can deduct the mortgage interest depends on how you use the money.

Home equity loans, HELOCs, and cash-out refinancing: Beware of the mortgage interest deduction trap

A home equity loan, home equity line of credit (HELOC), and cash-out refinance all let you tap your home equity. You can deduct the interest on these loans if you use the proceeds to make capital improvements.

Capital improvements are any permanent improvements you make to your home that increase its value. Some examples include remodeling the kitchen or bathroom, building an addition, adding a swimming pool to the backyard, adding a central heating and cooling system, or installing a home security system.

So, let’s say you’re doing a cash-out refinance for home improvements (like that new kitchen you’ve been eyeing). You’re in luck! The interest on the loan is deductible. However, if you use that cash to pay off credit card debt or take a vacation, you won’t be able to deduct the interest on that portion of the loan.

The same rules apply to home equity loans and HELOCs.

Remember the good old days (before 2018) when you could deduct the interest on your home equity loan or home equity line of credit (HELOC), no matter how you spent the money? Well, that ship has sailed. Under the current tax law, you can only deduct interest on a home equity loan or HELOC if you use the funds to buy, build, or substantially improve the home.

In other words, if you’re using that HELOC to pay off personal debts, like student loans or a car loan, don’t expect the IRS to give you a tax break. Sorry, but no home improvement means no deduction.

Refinancing? Let your tax accountant know!

If you’re considering refinancing—especially a cash-out refinance—you need to let your tax accountant know. Why?

Cash-out refinances can get tricky on the tax front.

Let’s say you refinance, pulling out $100,000 of equity. You use $60,000 for a capital improvement project, $20,000 to refinance credit card debt, and the remaining $20,000 for your daughter’s wedding.

A portion of your mortgage interest is deductible, but some of it—the amount used to refinance credit card debt and give your daughter the wedding of her dreams—is not deductible. Unfortunately, the Form 1098 you receive showing how much money you paid in interest last year won’t separate deductible and non-deductible interest. You’ll need to prorate it based on how you used the mortgage proceeds.

There might be other costs associated with refinancing a mortgage or tapping your home’s equity that affect your taxes. For example:

• You can deduct any mortgage points paid to the lender over the life of the loan.
• Other settlement fees and closing costs add to your basis in the property, meaning they help reduce any taxable gain you might have when you sell the home.
• Property taxes and prepaid interest paid at closing affect your tax deductions.

It’s best to keep your tax professional in the loop to ensure you’re playing by the rules and taking advantage of all the available tax savings.

Deducting mortgage interest on a rental property

If you’re refinancing a rental property, you’ll be happy to know that you can still deduct the mortgage interest—but with a twist. Unlike your primary residence, the interest on a rental property is considered a business expense. This means you can deduct the interest on your refinanced loan on Schedule E—the same form where you report other rental income and expenses.

Here’s the good news: you can deduct all of the interest on the loan, not just up to certain limits like with a personal residence. This can be a big advantage when managing a rental property because it reduces your taxable rental income, potentially lowering your overall tax liability.

But, as always, there are a few things to keep in mind. If you do a cash-out refinance on your rental property, how you use the funds affects your deductions. If you use the money to improve the rental property, you can deduct the interest as a business expense. However, if you use the cash for personal expenses like paying off debt or buying a car, the interest on that portion of the loan is not tax deductible.

To sum it up, the IRS is more flexible when it comes to deducting mortgage interest on a rental property, but the key is keeping careful records of how you use the loan funds. As always, make sure to work with your tax advisor to maximize your deductions while staying compliant with the rules.

Get solid advice on your refinance tax implications

If your head is spinning right now, don’t sweat it. We can help you understand the tax consequences of refinancing your mortgage loan on your primary residence, vacation home, or rental property.

Just keep us in the loop—especially if you’re doing a cash-out refinance. We can make sure to report everything to the Internal Revenue Service correctly and leverage tax deductions to lower your taxable income.

After all, refinancing is supposed to save you money—not create more stress!