Your Mortgage : Untangling the Mess Refinancing Made of Your 1993 Income Taxes

WASHINGTON —  In the wake of the biggest refinancing boom of the century--stretching from early 1992 through last December--large numbers of unsuspecting homeowners could be heading for tax trouble April 15. Many of them could also be overpaying on taxes, thanks to an easy-to-miss write-off that could shave their 1993 bills by hundreds of dollars.

To make sure you’re a fully informed refinancer, here’s a tax season update on issues that top accountants say even sophisticated homeowners misunderstand.

Start with the easy-to-miss write-off that’s most commonly ignored by the new wave of refinancers: Those non-deductible “points” you’ve been capitalizing from your previous refinancing.

Thousands of homeowners across the country have refinanced not just once in the past several years, but twice or even more. They refinanced their 10% and 11% loans from the 1980s when mortgage rates dropped into the low 9s. Then they refinanced again--probably during 1993--when mortgage rates hit the 7s or even below.

On each of their refinancings, they typically paid mortgage points to the lender. Each point is the equivalent of 1% of the mortgage amount and is collected during the loan closing process. Under federal tax law, points on refinancings of principal residences generally cannot be deducted in the year of the transaction. Instead they must be capitalized--that is, deducted pro rata over the life of the loan. For example, if you paid three points on a $200,000 30-year refi loan, you could only write off one-thirtieth of the $6,000 a year, or $200.

Say you refinanced in late 1991 and deducted $200 a year in points on your 1991 and 1992 federal income tax returns. If you then refinanced that loan in 1993 to catch last fall’s historic low rates, you generated the deduction that’s so easy to miss: You now write off the $5,600 you’ve been carrying in undeducted points from the 1991 refinancing on your 1993 return. And if you were fortunate enough to walk away with one of 1993’s plum refi prizes--a zero-point mortgage at an attractive rate--you won’t need to start capitalizing points again on the new loan.

Another brief piece of advice on refi points: If you can show that a portion of the proceeds of your refinancing was used to make substantial improvements on your home--like adding a deck, a new kitchen or bathroom--then part of your refi points may indeed be deductible April 15.

Say you refinanced the $100,000 existing loan on your $200,000 house last year, replacing it with a $150,000 new mortgage that cost you three points ($4,500) at closing. You pulled out the extra money to finance an addition to the home that cost you $50,000. In the IRS’s eyes, $50,000 of your $150,000 refi loan now counts as “acquisition indebtedness”--the tax equivalent of purchasing part of a brand new home.

As a result, you can now write off one-third ($1,500) of the $4,500 in points--that is, the same ratio as the $50,000 improvements bear to the full $150,000 loan amount. The $3,000 balance of points must be capitalized over the 30-year loan term, like any other refi.

A third and final item of widespread confusion among 1993 refinancers, according to accountants:

The federal ceiling on mortgage interest deductibility. Basically the rule works like this: When you refinance, you can’t deduct your mortgage interest payments on loan amounts that exceed your original “acquisition indebtedness” plus $100,000.

Confused? Never heard of that? Join the crowd. Here’s what it means. Acquisition indebtedness is the loan amount you borrow to “acquire, construct or substantially improve” your home. Say you buy a house for $200,000 and take out a first deed of trust for $100,000. Your acquisition indebtedness, for federal tax purposes, is $100,000.

As you pay off the principal amount over the years, your acquisition indebtedness declines. If you’ve paid back $10,000 of the $100,000 principal, your acquisition indebtedness stands at $90,000. Acquisition indebtedness can also increase, if you borrow funds that are used to expand or improve the house substantially, as in the $4,500 points example above.

The tax problem for refinancers arises when they go for mortgage amounts that exceed the formula of acquisition indebtedness plus $100,000. For example, say you bought a home for $300,000 in 1982 with a first mortgage of $200,000. In 1988 you refinanced for $300,000, based on a property value of $500,000. Last year you decided to refinance again--this time for $400,000, rather than miss out on 1993’s bargain-basement rates.

Now for the bad news: You won’t be able to write off the interest on about $100,000 worth of the new loan. That’s because your acquisition indebtedness is below $200,000--the balance on the original 1982 loan--and you’ve already taken out the maximum $100,000 home equity debt via the 1988 refinancing.

The bottom line on multiple refis: Before writing off your mortgage interest as you’ve always done in the past, check your acquisition indebtedness math. You could find yourself on the wrong side of IRS’s deductibility rules.

Distributed by the Washington Post Writers Group.