What Closing Costs Are Tax Deductible When Refinancing?
Demystify tax deductions for refinance closing costs. Understand what's deductible and how to accurately claim your benefits.
Refinancing a home loan can present an opportunity to adjust mortgage terms or access home equity. As homeowners navigate this process, questions often arise regarding the tax implications of associated closing costs. While many closing costs are not tax-deductible, certain expenses may offer tax benefits, potentially reducing a homeowner’s tax liability. Understanding which costs qualify for a deduction and how to claim them is important for tax planning.
Identifying Deductible and Non-Deductible Costs
When refinancing a home, various fees and charges are incurred at closing. The Internal Revenue Service (IRS) distinguishes between costs that represent prepaid interest, which may be deductible, and fees for services, which typically are not. This distinction is important for determining potential tax benefits.
Points, also known as loan origination fees, discount points, or loan discounts, are a common closing cost that can be tax-deductible. These charges are considered prepaid interest and are often expressed as a percentage of the loan amount, with one point equaling one percent of the loan.
For a refinanced mortgage, points generally cannot be deducted in full in the year they are paid, unlike points paid on an original home purchase. Instead, points on a refinance must be deducted ratably over the life of the loan. An exception allows for immediate deduction of points if a portion of the refinanced loan is used for substantial home improvements.
Another potentially deductible closing cost involves real estate taxes paid at closing. If property taxes are collected by the lender at closing, these amounts are generally deductible in the year they are paid. However, the deduction for state and local taxes, including property taxes, is subject to a limitation of $10,000 per household annually. This cap applies to the total of state and local income taxes or sales taxes, plus property taxes.
Many other closing costs are typically not tax-deductible because they are considered fees for services rather than interest. These non-deductible expenses include:
Appraisal fees
Title insurance
Attorney fees
Recording fees
Credit report fees
Inspection costs
Legal fees for document preparation
While these costs are not deductible in the year of the refinance, some, like owner’s title insurance and abstract fees, may be added to the home’s cost basis, which can reduce capital gains tax when the home is eventually sold.
Claiming Your Refinancing Deductions
Claiming tax deductions for refinancing costs requires adherence to specific Internal Revenue Service (IRS) guidelines and proper documentation. Homeowners who itemize their deductions on their tax return can generally claim these benefits.
For points paid on a refinanced mortgage, the deduction is spread out over the life of the loan. This means a small portion of the total points paid is deducted each year. Lenders typically provide information on the amortized amount of points, and this annual deduction is calculated by dividing the total points by the number of payments over the loan term. If the refinanced mortgage is later paid off, for example, by selling the home or refinancing again, any remaining unamortized points from the original refinance may be deductible in the year the loan is satisfied.
It is important to confirm that real estate taxes were indeed paid at closing and are not merely amounts set aside for future tax payments through an escrow account.
Homeowners claim these deductions on Schedule A, Itemized Deductions. The mortgage interest, which includes the deductible portion of points, is reported in the appropriate section of Schedule A. Real estate taxes are also reported on Schedule A.
To substantiate these deductions, accurate record-keeping is essential. The Closing Disclosure, previously known as the HUD-1 Settlement Statement, is a primary document that details all fees and charges paid at closing. Lenders are also required to send Form 1098, Mortgage Interest Statement, by the end of January each year if $600 or more in mortgage interest, including points, was paid during the year. This form provides the total mortgage interest paid, which includes any deductible points, making it a crucial document for tax preparation. If a homeowner refinanced during the year, they might receive a Form 1098 from both their original and new lenders.