From Bill Bischoff, “The Tax Guy”, via Marketwatch.com, comes the clearest explanation I’ve seen on the deductibility of the costs of refinancing your mortgage.  Clear is a relative term here, though.

Caution: You might want some coffee first.

If you are among the many who refinanced their home mortgages last year, you are probably in line for some often-overlooked tax deductions on your 2013 Form 1040. Here’s what you need to know.

Refinancing tax deduction basics

You are generally allowed to immediately deduct refinancing points to take out additional mortgage debt used to finance improvements to your principal residence. However, points paid to refinance the remaining balance of the old loan must be amortized over the new loan’s life.

Example 1: Say your old mortgage was $200,000, and you refinanced by taking out a new 15-year $300,000 mortgage. You spent the additional $100,000 of debt to pay for a new den, a kitchen remodel, new landscaping, and assorted other home improvements. You paid 1-1/2 points ($4,500) to get the new loan.

You can immediately deduct one-third ($100,000/$300,000) of the refinancing points, or $1,500, on your 2013 return as long as you paid at least that amount out of your own pocket to get the new loan.

You can claim amortization deductions for the remaining two-thirds ($200,000/$300,000) of the refinancing points, or $3,000, over the new loan’s 15-year term (180 months). So you can deduct $16.67 ($3,000 divided by 180 months) for each month the new loan was outstanding during 2013. In 2014 and beyond, continue claiming amortization deductions of $16.67 a month for as long as the new loan remains outstanding.

Note: If you rolled all the refinancing costs, including the points, into the balance of the new loan, you must amortize the entire amount of the points over the term of the new loan (no immediate deduction in this case).

Example 2: Say you simply refinanced your old mortgage last year without taking on any additional debt. In this case, you can amortize the points over the life of the new loan. For example, if on July 1, 2013 you paid $4,500 in points for a new 15-year mortgage (180 months) with the same principal balance as your old loan, your 2013 amortization deduction is $150 ($4,500 divided by 180 months times 6 months). Your amortization write-offs will continue in 2014 and beyond, at the rate of $25 a month ($300 a year), for as long as the new loan remains outstanding.

Deduct unamortized balance of points from earlier refinancing

Serial refinancers take note: If you had previously refinanced your mortgage and paid points, you probably have a good-sized unamortized (not-yet-deducted) balance for those points. You can deduct that entire unamortized amount when you refinance again.

Example 3: Say the mortgage you refinanced last year was taken out in a previous refinancing deal done five years earlier, back in 2008. At that time you paid $4,500 in points for a 30-year loan. You should have $3,750 of unamortized (not-yet-deducted) points left over from the 2008 loan (25/30 of the original $4,500 amount). On your 2013 return, please remember to deduct the $3,750. Please also remember to claim your rightful deductions for points on the new loan, as explained earlier.

If you refinanced and yanked out cash

Say the balance of your old mortgage (incurred when you bought the home) was $325,000 when you refinanced on July 1, 2013. On that date, you took out a new 20-year $450,000 mortgage and paid 1 point, or $4,500, for the privilege. You used the $125,000 from the new mortgage to eliminate credit card balances, pay off your car loans, and to cover various and sundry other personal outlays. As far as the IRS is concerned, you now have two separate new mortgages.

The first $325,000 of the new loan (the balance on your old mortgage when you paid it off) is treated as “home acquisition debt.” The interest on that amount of the new loan qualifies as an itemized deduction to be claimed on Line 10 of Schedule A (Itemized Deductions).

The last $125,000 of the new loan (the excess of the new loan’s $450,000 principal amount over the $325,000 balance of the old mortgage) is treated as “home equity debt.” The interest on home equity debt also potentially qualifies as an itemized deduction to be claimed on Line 10 of Schedule A. But there’s a twist: you can only deduct the interest on the first $100,000 of home equity debt. The interest on the extra $25,000 is considered a nondeductible personal expense (unless, for instance, you used the $25,000 to finance expenditures for your small business). So you can only deduct 94.44% ($425,000/$450,000) of the total mortgage interest on Schedule A.

Now let’s talk about the points you paid to get the new mortgage. You can amortize the points related to the home acquisition debt part of the new loan ($3,250 in our example) over the life of the new loan. The points related to the first $100,000 of the home equity part of the new loan ($1,000 in our example) can also be amortized over the life of the new loan. The points related to the last $25,000 of the home equity part of the new loan ($250 in our example) are nondeductible (unless, for instance, you used the $25,000 to finance expenditures for your small business).

Finally, as explained earlier, don’t forget to deduct any unamortized points from the mortgage you refinanced.

Where to claim deductions

Deduct interest from your new mortgage on Line 10 of Schedule A (Itemized Deductions). Claim deductions for points paid to obtain the new loan on Line 10 of Schedule A if the points were reported to you on a Form 1098 (Mortgage Interest Statement) received from the lender (they probably were). Deductions for points that were not reported to you on a Form 1098 (somewhat unusual) should be claimed on Line 12 of Schedule A.

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