Many people who take deductions on their tax returns think the law is straightforward--until they are audited by the Internal Revenue Service (IRS). If the filers took deductions for all closing costs related to real estate transactions, the IRS will both scale back their deductions and charge them penalties and interest because they made larger ones than were allowed. Deductions will differ based on whether they are taken on a primary residence, vacation or rental property, or on financed property the owner uses for his business. An understanding of the rules regarding the expenses of refinancing will help you avoid the pain of being penalized by the IRS for doing it wrong.
Deduct only the points when you refinance your primary residence. Understand that those points can be deducted for the full term of the loan, but not in the year in which they were incurred. For example, let's say you paid $1,800 in points on a new mortgage that is for 15 years and that you are obliged to make 180 monthly payments. Divide the $1,800 by 180 payments to arrive at $10 deduction each month, or $120 annually on your return. All other fees due the lender, such as underwriting, processing and others, are not deductible. The amount of the points on your existing mortgage loan that were not deducted may now be deducted on your current tax return, if your refinancing was with another lender. If your new loan is with the same lender, both the points from your old loan that weren't deducted, and the new points, must be prorated over the life of your new loan.
Refinance your mortgage loan and use part of the proceeds to make substantial improvements to your primary residence. In this case, determine the percentage of the proceeds of your new loan and take an immediate deduction for the same percentage of your new points. For example, suppose your new loan is $300,000 and $100,000 (1/3) of it was used for a room addition. If you paid $3,000 in points, $1,000 (1/3) can be deducted this year and the balance is deductible for the term of the loan.
Refinance real estate that you rent out or use in your business. In this case, all expenses in connection with securing the loan are deductible including points, underwriting fees, appraisals and others. However, they must be prorated for the term of your new loan.
Know how to handle other closing costs. There are a number of closing costs aside from points such as attorney and appraisal fees, title search expenses, and other charges by the lender. They are not deductible but can be used to increase the cost basis of the property which will positively affect taxes when you sell the property.
Seek tax advice. The Internal Revenue Code can be confusing so you should consult with your attorney or accountant before taking deductions when you refinance a piece of real estate. The cost savings can be substantial, as are the penalties if you do it incorrectly.