If you’ve owned your home for at least a year, you’re probably already aware of the mortgage interest tax deduction that homeowners qualify for. That deduction is one of the many reasons buying real estate can be financially advantageous and often motivates long-time renters to become first-time homebuyers.

When you refinance your home, you’re essentially taking out a new mortgage. Depending on how you refinance, that may mean new tax ramifications. Let’s take a look at a couple of different refinancing scenarios, so you can choose the best refinancing option for your personal circumstances.

Mortgage Interest Deduction Basics

For the tax year 2020, homeowners who are single filers, heads of household, or file jointly as a married couple can deduct the interest they paid on a mortgage of up to $750,000 in size.  Filers who own both a primary and secondary residence can deduct mortgage interest paid on both homes, but again, the loan principal limit is $750,000. Interest paid on loans in excess of that figure is not deductible.  Married taxpayers who file separately can deduct up to $375,000 each. In terms of the mortgage interest tax deduction, there is no financial penalty for married couples who choose the separate filing option.

There are a couple of exceptions, where mortgage interest deductible limits are higher. That’s because previous years’ tax codes allowed for deductions on larger loan amounts. If someone took out a mortgage before October 13, 1987, there is no loan principal limit and all of the interest paid in 2020 is fully deductible. If a person bought their home between October 14, 1987 and December 16, 2017, they can deduct interest paid on up to $1 million in mortgage debt.

The Simplest Refinancing Scenario

If you refinance your home simply to secure a better mortgage interest rate—that is, you just roll the total amount owed on your original mortgage into a new loan—the basic rules we just discussed apply to your taxes. Any interest you paid in 2020 on up to $750,000 in mortgage debt is deductible. A mortgage calculator can help you predict how much interest you’ll pay on any refinancing deal you’re considering. That’s good information to have on hand as you review various loan offers. Keeping your entire financial picture in mind, including your strategy for tax savings, is important when making any large financial commitment.  

Cash-out Refinancing Changes Things

If you refinance into a mortgage that’s larger than your original to access some of the equity you have in your home, your mortgage interest tax deduction will change, based on how you use the cash proceeds from your new loan.

If you use the cash (equity) you withdrew from your home to substantially improve your property—whether that means replacing your roof, building an addition, or installing an inground pool—you may be able to deduct interest up to the regular $750,000 principal limit.1

If, however, you use the proceeds from cash-out refinancing for another purpose—to pay your kids’ college tuition, pay down high-interest credit card debt, or take that trip to Fiji you’ve always dreamed of, for example—you can only take a mortgage interest deduction on your mortgage principal (up to $750,000 as we’ve mentioned) minus the amount you withdrew as cash.

Is HELOC Interest Deductible?

Many homeowners choose the convenience of home equity lines of credit to borrow against the equity they’ve built up in their homes. HELOCs offer some flexibility because you can draw on them in incremental amounts as you need extra cash. You only pay interest on the actual amount you use, not your entire credit limit. HELOCs sometimes come with the extra advantage of lower interest rates, though HELOCs are variable-rate loans and the rate you pay will likely vary from year to year. Some HELOCs also allow borrowers to defer payments during an initial draw period, which is usually about 10 years, after which they must pay down their loan balance or risk defaulting on their loan and losing their homes.

When it comes to mortgage interest, the IRS treats HELOCs in a way similar to how they treat cash-out refinancing. If you use the money you borrow with a HELOC to make home improvements, you might be able to deduct the interest you pay on the amount you borrow, again up to a $750,000 limit.1 If you don’t use your loan proceeds for a qualifying purpose, the interest you pay on it isn’t deductible.

What You’ll Need to Take a Mortgage Interest Deduction

If you have less than $600 in mortgage interest, you don’t need to document it when you file your tax form. Simply enter the amount you paid as an itemized deduction. If you paid more than $600 in interest, your lender will provide you with Form 1098 as proof of payment. Haven’t received your 1098 yet? Mistakes happen sometimes! Contact your mortgage lender or servicer to request it. You must file it along with your return to receive your full deduction.

To Itemize or Not to Itemize?

The IRS offers a simple way to take a tax deduction without itemizing each eligible expense on your tax return. It’s called the standard deduction. The amount of your deduction varies under the standard deduction system. Single people and married people filing separately can deduct $12,400 without documenting a thing. Couples who file jointly can deduct $24,800 and heads of household can deduct $18,650.

Whether it makes sense for you to itemize depends on the amount of money you paid in mortgage interest and whether you are eligible to take other deductions. For example, depending on your income, you may be eligible to deduct student loan interest of up to $2500. You may be able to deduct medical expenses if they reach a certain threshold. Donations to registered charities are also tax-deductible. You’ll have to crunch some numbers when deciding between taking the standard deduction—the easy, breezy way to go—and taking the time to itemize and document your deductions. If the total you can take in itemized deductions exceeds the standard deduction you’re eligible for, itemizing usually makes sense.

If you typically prepare your own taxes and decide to follow the itemizing route, be sure to study the IRS’s list of potential deductions to be sure you’re taking every single one that’s available to you. But if the DYI approach isn’t your style, a proactive licensed tax advisor will provide you with a list of deductions you might consider taking. In the process of preparing your taxes, he or she can also do the math for you and tell you whether taking the standard deduction or itemizing makes better sense for you. Tax savings, of course, makes sense for everyone.

Figure Lending LLC dba Figure. 15720 Brixham Hill Avenue, Suite 300, Charlotte, NC 28277. (888) 819-6388. NMLS ID 1717824. For licensing information go to www.nmlsconsumeraccess.org. Equal Housing Opportunity.

1 You should consult a tax advisor regarding the deductibility of interest and charges associated with your refinance or HELOC.

This article is published for informational purposes only and is not intended to provide, and should not be relied upon for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before entering into any transaction.