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If you refinanced last year, be sure to get full tax advantages

Monday, January 13, 2003

By Eileen Putman, The Associated Press

WASHINGTON -- Riding record-low interest rates, the white-hot mortgage industry lured many Americans into refinancing or buying homes in 2002, but taxpayers must be careful when they figure deductions for mortgage costs.

Here's why those deductions can be tricky:

Mortgage interest paid in 2002 is generally deductible -- whether for a new, existing or refinanced home loan -- within certain limits. Mortgage closing costs, however, are not.

Some "points" paid to lenders for a 2002 mortgage are fully deductible as interest, but others must be deducted over the life of the loan. A point is a fee -- one point is equal to 1 percent of the loan principal -- mortgage lenders charge borrowers.

For refinanced mortgages, point deductibility depends in part on whether the mortgage was used to pay for home improvements or simply to lower an existing loan's interest rate.

Many taxpayers will grapple with mortgage deductibility questions on their 2002 tax returns. That's because as mortgage interest rates dipped last year to their lowest in decades, Americans borrowed an estimated $2.3 trillion -- higher than any previous year -- to buy or refinance single-family homes, according to Frank Nothaft, chief economist for Freddie Mac, which buys mortgages from lenders.

Two in three mortgages were refinances, Nothaft said. Often, homeowners refinanced for higher amounts than their existing mortgages to take home equity out as cash or to pay for home improvements.

The Internal Revenue Service has several publications to help taxpayers determine how to deduct mortgage costs: Publication 936, "Home Mortgage Interest Deduction;" Publication 523, "Selling Your Home;" Publication 527, "Residential Rental Property;" and Publication 530, "Tax Information for First-Time Homeowners." All may be downloaded from the IRS Web site, www.irs.gov, or by calling IRS at 1-800-829-3676 (1-800-TAX-FORM).

Here's a quick summary:

To deduct mortgage costs, taxpayers must file the 1040 income tax form and itemize deductions on the form's Schedule A.

Interest you paid on a loan secured by your home qualifies as mortgage interest. The loan can be for your main home as well as a second home. Second mortgages, lines of credit and home equity loans also qualify for the mortgage interest deduction.

But if a loan used to buy, build or improve your home is more than $1 million -- or if your home equity loan is more than $100,000 -- you may not deduct the interest on the portion of the loan exceeding these amounts. See IRS Publication 936 for more information.

If your mortgage is an existing one -- you took it out before 2002 and simply continued to pay on it last year -- the interest you paid in 2002 is deductible in most cases. Your mortgage lender will send you form 1098 reporting your total interest for the year.

If the lender charged you points for a 2002 mortgage, you may fully deduct those points only if your situation meets nine conditions stated in Publication 936. Otherwise, you must deduct the points over the life of the loan.

Generally, points paid to refinance an existing mortgage are not fully deductible the year in which they are paid. An exception: points on the portion of a refinanced mortgage used to make improvements on your main home are fully deductible in the year the loan was opened, as long as they meet the Publication 936 conditions. Otherwise, they, too, must be deducted over the life of the loan.

Suppose, for example, you had an existing $100,000 mortgage on a home appraised at $250,000. You refinanced in 2002, taking out your home equity to pay for a $150,000 addition that will improve your home's value or life span or adapt your home to new uses. Points associated with the $150,000 portion of the mortgage -- but not the entire $250,000 loan amount -- may be fully deductible for 2002 if you meet the tests in Publication 936.

If you ended a mortgage early in 2002 -- by refinancing or selling the home, for example -- and you had spread your points deduction over the life of the old mortgage, you can deduct for 2002 any remaining balance of those points you had not yet deducted.

Mortgage closing costs are not deductible. These include appraisal, notary, deed preparation or VA funding fees, as well as mortgage insurance premiums.

Expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest, though you may deduct them over the life of the loan on Schedule E of form 1040.

One last note: if you refinanced in 2002 to lower your interest rate but kept the same mortgage balance, you'll have less mortgage interest to deduct this year than you had for 2001 -- which will reduce your tax benefit.

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