Lower Loan Payments
May Slash Deductions

There is a downside to the lower mortgage payments that millions of Americans are now paying on their homes: higher taxes.

For many Americans, the biggest tax break they get is the deduction for the interest shelled out every year on their mortgage. But those deductions could shrink by an estimated $10 billion this year, causing homeowners to pay close to $1.7 billion more in taxes, says Douglas Duncan of the Mortgage Bankers Association of America.

The reason: A record 7.8 million households refinanced this year to take advantage of some of the lowest rates in decades. In the process, many slashed the amount of interest they pay each year on their mortgage, whittling down the size of their tax deduction.

"We're letting clients know" that they may wind up owing more than they expect in taxes, says Rick Bloom, an accountant and attorney in Farmington Hills, Mich. That is especially true for homeowners who refinanced early in the year and now have many months of lower interest payments. Mr. Bloom is advising people who have significantly cut their interest rates to put some money aside in an interest-bearing account.

But there are ways to avoid or minimize the tax hit. Some are simple steps, such as taking any savings and putting it into your 401(k) where it will also be safe from taxes at least in the short term. Another approach involves careful treatment of mortgage points -- the costs you pay to get a loan or to pay down the rate on a loan. People who have refinanced more than once may be able to take immediate deductions for points paid in the past.

There is a lot of money at stake: In 2000, an estimated 34.9 million households took $295.7 billion in mortgage-interest deductions, up 56% from a decade earlier. Typically, mortgage interest is deductible on loans up to $1 million that are used to buy, build or improve one's home.

In addition, taxpayers can deduct interest on home-equity loans of as much as $100,000 even if the proceeds are used for purposes other than home improvement. Such loans have been extremely common this year because of their unusually low rates. Deducting the interest on these loans may help alleviate the tax burden for taxpayers who have seen their other interest payments decline.

Diemha Segal of Long Beach, Calif., saw her mortgage deduction shrink when she refinanced two home loans with a combined balance of about $375,000 early this year. Even though she took out $15,000 in cash, Ms. Segal managed to shave nearly $550 off her monthly payments.

Still, Ms. Segal figures she is still better off refinancing. And with a new child, she and her husband expect additional child and child-care credits will help offset her higher taxable income as a result of smaller home-mortgage deduction.

The tax impact will be lower for the many people who take out additional cash when they refinance. About half the people refinancing generally do so. As a result, their mortgage deduction could remain the same -- or possibly increase -- even though their new loan carries a lower interest rate.

That is the case for William Moreno of Redondo Beach, Calif., whose interest payments didn't change much when he refinanced his loan. That is because he took out an extra $17,000 to pay for improvements to his home, while also shortening the length of his loan. Because he is using all of his loan to pay for his home and related improvements, he will be able to deduct all of the interest.

The treatment of mortgage points can be an important consideration in calculating the tax consequences of refinancing. Points paid to obtain an original home mortgage are usually fully deductible in the year paid. But when you refinance, you typically have to spread out the cost of the points over the life of the loan.

"That's sort of a disappointment" to people who had been counting on deducting the cost of all the points immediately, said Mark Luscombe, a principal analyst for the federal tax group at tax-publisher CCH in Riverwoods, Ill.

The good news is that if you are refinancing for a second time or more, you can immediately deduct the cost of all the unused points from the first loan. That can result in several thousand dollars' worth of additional deductions.

If you don't have enough deductions to offset your lower mortgage interest, try to pull forward expenses, where possible, to the current year. Consider dumping stock with big losses and use those losses to offset any capital gains. If your losses exceed your gains, you can deduct as much as $3,000 of net losses in most cases from your wages and other ordinary income. Consider prepaying state and property taxes or making charitable contributions.

Another strategy: Funnel a percentage equal to the savings generated by your refinanced loan to your 401(k) or other retirement plan that allows for pretax contributions. That way, you can still reduce your taxable income by the same amount that you save on your new loan.

For more details, taxpayers can visit www.irs.gov or review IRS Publication 936, "Home Mortgage Interest Deduction."

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