As an existing mortgage borrower, you already know that your mortgage interest is tax deductible. You may also know that you pay far more interest in the early years of a mortgage than you do later on. And the more interest you pay, the higher your deduction. Replacing your current mortgage loan with a refinance might lower your tax liability. And if you intend to use the refinance to consolidate credit card debt, the benefits would be even greater, because you'd be replacing non-deductible credit card interest with tax-deductible mortgage interest.
The IRS designates two types of mortgage debt: home acquisition debt, and home equity debt. Home acquisition debt is what you paid to buy the house. When you refinance, the amount of the new loan used to pay off the old loan qualifies as home acquisition debt. Any amount over that would be home equity debt. The following example will help clarify the point:
• Suppose Jane Doe owes $200,000 on her mortgage. She takes out a new mortgage for $225,000 and pays off her old mortgage. For tax purposes, $200,000 is home acquisition debt, and the remaining $25,000 is home equity debt.
Interest paid on home acquisition debt is generally tax deductible in its entirety. You can also deduct interest paid on the first $100,000 of home equity debt.
Confused? Don't worry…your tax advisor will happily clear things up. The short of it is that refinancing can help you manage your tax liability.