If you refinanced in 2002, watch out for the tax hit - Economic Observer

USA Today (Society for the Advancement of Education), March, 2003 by Jeff A. Schnepper

SOMETIMES, you really do have to suffer the pain to get the gain. It may feel lovely to knock your mortgage rate from, say, 9% to 6%, but make sure you've planned for the tax hit. (Let's make this simple. Unless you itemize, the rest of this just doesn't apply to you. Put a big smile on your standard deduction face.)

You have now locked in the lowest interest rates in 30 years, and the difference between the rates is stuffing your pockets with dollars that would have gone to your mortgage company. Alternatively, you could be paying the same amount of dollars out of pocket and be paying off your home in fewer years. In any case, you're a big winner!

However, if you itemize your deductions, you are going to pay a price for refinancing. If you pay less, you deduct less. If you refinanced a $100,000 loan from 9% to 6%, that's a 3% difference, or approximately $3,000 that you don't get to deduct.

The earlier in the year you refinanced, the more of that $3,000 you are going to lose. Over the 12 months of 2003, you are going to lose the whole difference. (I know that the principal is reduced with each payment, so my numbers are off, but I'm trying to keep it simple so that you don't get lost in the amortization computations.)

Nevertheless, you are still way ahead, no matter how much you lose. With a top 2002 Federal tax bracket of 38.6%, a loss of $3,000 in interest deductions costs you $1,158. Since you didn't pay $3,000, you are still $1,842 ahead. Moreover, clearly you put aside at least $1,158 in cash out of the $3,000 saved to pay the additional tax--right?

Unexpected consequences

The reduction in your interest deduction may have other consequences. You only itemize if your itemized deductions exceed your standard deduction. For 2002, that's $4,700 for a single taxpayer and $7,850 for a joint return. For 2003, those numbers increase to $4,750 and $7,950, respectively. The reduced deduction may put you below those numbers. In that case, you would take the standard deduction instead.

There may be some sunshine behind the cloud. Unlike when you bought your house, any points you pay when you refinance normally are amortized over the life of the loan. This is done on a monthly basis. So, say you refinanced a $100,000 loan for 20 years at a cost of three points, or 3%. That $3,000 would be divided by the loan term--240 months--for a $12.50-per-month deduction. If you took out the loan on July 1, you would have six months, or a deduction of $75. Next year, you would take a full year's deduction of $150.

The bad news is that you can't just deduct all the points. There is an exception if you refinanced for more than your original loan and used the difference to improve your home. Then, the percentage of points paid that represents the dollars used for the improvement can be deducted in the first year. Say your home has substantially appreciated and you were able to borrow $300,000 to refinance a $200,000 loan. You put $100,000 into improvements to your property. If you paid $3,000 in points (1%), one-third ($100,-000/$300,000), or $1,000, would be allowed in 2002. You would also get to deduct the additional $2,000 paid over the term of the loan. Over 240 months, that would give you an additional deduction of $8.33 per month.

Good news

The good news is that, if this isn't your first refinance, you will probably have what the tax pros call "unamortized points." Those are the points that you paid on your first refinance that haven't been allowed yet. Those points are allowed in full this year. So, say you refinanced July 1, 2001, and again July 1, 2002. On the first refinance, you paid $3,000 in points on a 30-year or 360-month note. Last year, you deducted six months worth of amortization, or $50 ($3,000 divided by 360 months, multiplied by six months). This year, you get to deduct the remaining $2,950 in full.

What else could you have done to make up for this year's loss? Did you make your Jan. 1 mortgage payment on Dec. 31? The payment was for the use of the money in December and will be allowed. Your mortgage company didn't receive it until 2003, so the interest won't be shown on its Form 1098. Remember to run an amortization schedule and add the additional 2002 interest payment on line 11 of your Schedule A.

In 2000, an estimated 34,900,000 tax returns claimed $295,700,000,000 in mortgage interest deductions. This year, a record 7,800,000 households refinanced to reduce their interest payments. According to Douglas Duncan of the Mortgage Bankers Association, an estimated $10,000,000,000 in interest has been saved in 2002. While he translates that into close to $1,700,000,-000 in additional taxes due, I translate that into $8,300,000,000 freed up for us to spend!

Run your own numbers. Make sure that you meet the safe harbors for withholdings and estimated payments. As George Leupold of Leupold Financial Planning Associates, Cherry Hill, N.J., succinctly put it, "Don't let the tax tail wag the financial planning dog." The bottom line is, unless you are in a tax bracket that is over 100%, a reduction in interest rates is going to save you real money, even after the tax loss.