Pay the Loan Down and Refinance Later? The IRS is Out To Getchya !

by Brian Brady

Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL

Author website

Rising real estate prices and serial “cash-out” refinance transactions has the IRS licking their chops. Mortgage interest deductions are limited to the acquisition indebtedness plus a maximum of $100,000 for home equity indebtedness. Scofflaws have taken advantage of the fact that the IRS is not able to track the segregation of loan transactions by loan proceeds usage. In fact, your friendly CPA has probably told you “not to worry about it” when you erroneously overdeduct the mortgage interest for the loans you’ve taken against your home.

That’s about to change. The IRS is requiring lenders to report any and all cash-out refinance transactions this year on the Form 1098. This now gives Big Brother an opportunity to segregate new loans by proceeds usage and set a trap for the willing tax scofflaw.

Let me give you an example: Bill and Jacqueline bought a beautiful home in Houston, TX for $250,000 in 1998. They put $100,000 down and took a $150,000, 30 year mortgage. They set their acquisition indebtedness at $150,000 but were reducing it as they paid the loan through an amortizing loan. In 2003, they refinanced $140,000 into a 15 year, low rate loan as their home value grew to $340,000. They plan to refinance their home in 2012 to pay for their twins education at the University of Texas. They recognize that they’ll need about $200,000 for the twins’ education but figure that they’ll be well under the acquisition indebtedness plus home equity indebtedness limit for tax deductibility of mortgages.

They’ll owe about $35,000, borrow $200,000, and be well under that figure…right?

WRONG. Acquisition Indebtedness is reduced by an amortizing loan, in their case, it is reduced to about $35,000. Add the $100,000 for the home equity indebtedness and their limit for the deductibility of interest will be closer to $135,000. The interest on $100,000 of that loan won’t be tax deductible, costing them about $2,000 to $4,000 in extra income taxes each year.

…and they WILL get caught. The IRS is following the money now. If you’ve used your home as an ATM and haven’t reinvested the proceeds or improved your property, you may get stuck owing YEARS of taxes.

Pick the right Realtor, mortgage professional, and CPA when buying a home. If you thought dealing with a professional was expensive, wait until you find out how much dealing with an amateur costs.