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As interest rates plummeted throughout 2020, mortgage refinancing became a major avenue to saving money in the midst of the coronavirus pandemic. But those who took the plunge need to be aware of how opting to refinance could affect their taxes insofar as deductions are concerned.

The Mortgage Bankers Association estimated that lenders originated some 7.1 million refinance loans last year. “The vast majority of owners are not even going to qualify to take the tax deductions,” said Holden Lewis, housing and mortgage expert at personal-finance website NerdWallet.

The Tax Cuts and Jobs Act of 2017 ultimately kept the mortgage interest deduction around, albeit with some changes, after some suggested the GOP may decide to jettison it.

But the Republican tax preform package did expand the standard deduction to $12,000 for individual filers and $24,000 for joint returns. In expanding the standard deduction, Republican lawmakers created a high bar for itemizing deductions to make more financial sense for taxpayers.

And with interest rates currently so low, most homeowners won’t be paying enough in interest each year for the deduction to be worthwhile, unless they have other deductions they can avail themselves of, experts say.

As a result, only “a really small subset of homeowners” need to worry about how the mortgage interest deduction was changed,” Lewis said.

How the mortgage interest deduction changed

The Tax Cuts and Jobs Act narrowed the amount of mortgage debt on which the interest is deductible. Prior to the legislation, homeowners could deduct interest on up to $1 million in mortgage debt if the original loan used to buy, build or improve a home was originated between October 1987 and December 2017. (For loans on homes purchased before 1987, mortgage interest on the total loan amount may be deductible, depending on eligibility.)

After the tax-reform package became law, the mortgage interest deduction limit was lowered. From 2017 onward, homeowners could only deduct interest on up to $750,000 in mortgage debt used to buy, build or improve a home. Homeowners with pre-existing mortgages were grandfathered in, meaning they could still deduct up interest on up to $1 million in mortgage debt if they received the loan before the 2017 cut-off.

So what does this all mean if you just refinanced last year? If your new loan was smaller than $750,000, you’re likely in the clear. “If you just refinanced the existing balance [on the loan] at that time and it was under $750,000, then you get the full interest deduction,” said Ryan Losi, a certified public account and executive vice president of Piascik, an accounting firm based in Virginia.

And if your original mortgage was from before 2017, you may be able to deduct the interest on up to $1 million in debt. “For purposes of knowing which limit applies (the older $1 million or the newer $750,000) the refinancing will generally relate back to the date of the original loan for purposes of the mortgage-interest deduction,” said Tim Todd, a certified public accountant and member of the American Institute of CPAs Financial Literacy Commission.

How were the loan proceeds used?

Many homeowners who used the low-rate opportunity last year to perform a cash-out refinance — meaning the principal on the new loan was larger than the original mortgage because they took out some of the built-up equity.

But if someone refinances more than the original loan, they are subject to the new limits put in place by the 2017 law, Todd said.

But even then, the added amount may or may not be deductible. “Now you have to do the interest-tracing rules to say what those proceeds were used for,” Losi said.

The Internal Revenue Service states on its website that any additional debt taken out through a refinancing that is “not used to buy, build, or substantially improve a qualified home isn’t home acquisition debt.”

Let’s say the original balance on the mortgage was $450,000, but the borrower refinanced and cashed out an additional $50,000. They may be able to deduct the interest on up to $500,000 in that mortgage debt depending on how they used the money they cashed out. If they funded a home renovation, such as converting a bedroom into an office, they’re in the clear. But if they used it to pay their child’s college tuition or buy a new car, only the original balance will be eligible for the deduction.

Additionally, the IRS clarified that “the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing.” So if a homeowner cashes out through a refinance and puts themselves above the $750,000 limit in place now, the additional amount may not be eligible.

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