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Is your home a tax trap?
September, 26th 2007
Have you refinanced your mortgage and taken a chunk of the equity in cash? Will you do so when your adjustable-rate loan resets its interest rate? If you fail to follow some little-known rules for calculating your home mortgage deduction, you may be writing off too much interest.

Instead of saving on taxes, you could wind up owing them. In general, the IRS lets you deduct 100% of the interest you pay on one or more home mortgages, up to a total loan value of $1 million.

But when you refinance and withdraw cash, the rules change: Only the interest on your original mortgage balance, plus an additional $100,000, qualifies for a deduction. (If you want to take out more cash, use a home-equity loan or line of credit. The law allows a separate deduction for interest on borrowings of up to $100,000.)

Its easy to get this deduction wrong. Banks and mortgage companies send borrowers a Form 1098 early in the new year, which most use to prepare their taxes. This document shows total interest paid for the year, so many assume the number on the form is the one they should use in filing taxes. Schedule A, the tax form on which you enter home mortgage interest, makes no mention of limits on refi-related deductions, though the instruction booklet does.

Lenders seeking refi customers usually dont play up that little catch. They have no incentive to educate borrowers about the tax consequences of refinancing, says Douglas Dachille, CEO of First Principles Capital Management, a New York investment firm.

Their promotions may include a fine-print caveat to check on the tax effects of a refinancing, but they dont spell out the rules. Dachille says this refi issue came to the fore when he was considering investing in subprime mortgage-backed securities. The tax provision could affect homeowners cash flow, so its yet another reason to avoid the subprime market.

Heres how the refi tax trap works. Lets say you borrowed $500,000 at 8% in 1998 to buy your house. By 2003, the house had appreciated substantially and the mortgage balance had been whittled down to $450,000. Then you refinanced, taking a new loan of $650,000 at 6%. At tax time, Form 1098 would show that you forked over about $39,000 in interest on the $650,000 mortgage in 2003.

Increasing Interest

If you use that $39,000 figure to calculate your annual mortgage interest deduction and youre in the 33% marginal tax bracket, you would wind up taking $1,980 more in deductions than youre entitled to, according to William Lazor, a CPA at Kronick Kalada Berdy in Kingston, Pa.

Thats because you may take a deduction on a mortgage of only $550,000the $450,000 left on the original loan plus $100,000. On $550,000, the interest paid would be $33,000, says Lazor.
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