Refinancing the mortgage on an investment property can save the homeowner a lot of money, especially if the current mortgage has a high interest rate. But, there are tax implications of refinancing a rental property, and they differ depending upon whether the property is the owner's residence, a vacation home or renovation project or a rental property from which the homeowner draws income. The greatest impact is on the deduction of mortgage interest expenses, which will vary depending on whether the property is a qualified home and how often it is rented out.
TL;DR (Too Long; Didn't Read)
When you refinance an investment property, the chances are good that your reduced interest rates will result in an overall decrease in the amount of interest paid. Consequently, this will lower the size of your interest deduction on your tax return.
What Is a Qualified Home?
A qualified home for purposes of deducting mortgage interest is either the homeowner's personal residence or a second home used for personal purposes. If the property is used as a rental property, the mortgage interest is deducted as a rental expense. If the property is a qualified home, the owner can deduct the mortgage interest on his personal tax return, thereby reducing his taxable income and consequently, his tax bill. If the owner of an investment property uses the property as her primary residence or uses it as a vacation home, there are tax benefits of refinancing and she can count her mortgage interest as a deduction.
Refinance of Investment Property
In some ways, an investment property used as a rental property is treated as a business by the IRS. Rental income must be reported on Schedule E of the homeowner's federal tax return, which is the same form used by business owners to report supplemental income. Like other businesses, a rental property will generate income but will also generate associated expenses, such as property taxes, mortgage interest, depreciation, repairs, utilities, insurance, advertising and more. The owner of a rental property who collects rental income can deduct these expenses, thus reducing the amount of total taxable income and therefore, reducing the tax.
When an investment property is refinanced, the interest rate on the new loan is typically lower than it is on the original loan. The lower interest rate on the new loan will result in less interest overall, which means the interest deduction will be lower, and the owner will ultimately have to pay more taxes. For example, if the current mortgage is a 30-year loan with a balance of $100,000 and an interest rate of 5 percent, using amortization, the balance on the loan after five years will be $91,828.73. Over the next year, the owner would pay $4,158.37 in interest. However, if the $91,828.73 is refinanced at 3 percent, the homeowner will only pay $2,953.42 in interest over the next year, which saves money on interest, but decreases the amount of the tax deduction.
If the taxpayer refinances the property for more than the loan balance – the taxpayer takes cash out of the property – the interest deduction for the new loan generally cannot include any interest paid on the amount in excess of the previous mortgage. So if the balance on the previous mortgage is $91,828.73 and the new loan is for $100,000.00, any interest paid over the next year on the $8,171.27 difference is likely not deductible as a rental expense, unless the funds were used for certain improvements on the property.
Investment Properties Used for Personal Purposes
An investment property that is used solely as a vacation home will have no rental income, and therefore, the expenses associated with that property cannot be used as business deductions, other than the regular deductions for a homeowner, which includes mortgage interest, but only for qualified homes. If the property is the homeowner's second home, it's a qualified home, and the owner can deduct the mortgage interest as if the property were his primary residence. However, if the owner owns three or more investment properties, she can only deduct the interest expense for the main residence and one of the vacation homes.
If the investment property is sometimes rented and sometimes used for personal purposes, the expenses that can be deducted must be allocated between rental expenses and personal expenses. For the home to qualify for the mortgage interest deduction on the full amount of interest paid, the owner must use it as a home for more than 14 days or for more than 10 percent of the number of days the home is rented out, whichever is longer. For example, if an investment property is occupied by the homeowner for nine months out of the year and he rents it out for three months of the year, the home is a qualified home and the interest can be deducted in full, because the homeowner is using the home more than 10 percent of the time. However, if the homeowner uses the property for only a week out of the year and rents it the rest of the year, the interest paid during the rental period can be deducted as a rental expense, but the interest paid during the week that the property is used for personal purposes cannot, because the home is not a qualified home.