By Pam Feely, CPA

Have your clients refinanced their homes? Did they adjust their withholding to cover the additional federal and state income taxes due in April 2004? Do you want to help them save taxes in the future by investing the freed-up cash from the refinancing in a Roth IRA?

This year, mortgage interest rates hit 40-year lows, and many of your clients probably took advantage of these lower rates. However, one of the things they may have overlooked was the resulting increase in their federal and state income taxes due to the lowered value of their mortgage-interest deduction. It’s not too late to look at your clients’ federal withholding, the amount of interest paid on the old loan before refinancing and the lower amount of interest they’re paying on their new loan.

Some of your clients may have refinanced their loan at least once already. If their loan was previously refinanced, any points paid on the previous loan will be deductible this year, assuming they closed the new loan in 2003. Many people are entitled to this deduction because they put the points into the loan amount on the earlier loan. As a result, when the loan is paid off via a refinance, the points are also “paid” and now can be deducted. This can amount to several thousand dollars since one point is one percent of the loan amount.

The cash savings generated by the lower mortgage pay off in the form of lower interest costs.

Point of order
However, a couple of pointers are in order. First, if the points were paid “up front” on the earlier loan, they should have been deducted in the same year in which the earlier loan originally closed. In addition, if the old loan was on a 30-year amortization schedule, 1/30th of the points should have been deducted each year if they were put into the loan. Therefore, it is the balance that is deducted when the new loan closes. This is a good opportunity to call your client’s tax advisor and see what was done.

Working with your client
If your client is bringing in his tax returns, you can figure out what was deducted pretty easily. To see if there are points not previously deducted available for deduction in 2003, look at Schedule A, Line 12, on your client’s 2002 return. There will be a description and an amount, generally small. Points paid at the time of refinancing, without substantial home improvements or an acquisition of a new home, are deducted over the life of the loan. If you don’t see any points on the prior return, but you know your client refinanced in 2001, look at his closing statement. There will be a line item on the closing statement indicating points or a percentage of the loan balance. If it is customary in your area, these points will be deductible over the life of the loan or at the time the loan is paid off or refinanced.

Tax savings
Depending on the size of the mortgage, these points can generate nice tax savings. For example, assume the points paid on a $150,000 loan were $1,500 in July 2001. The terms were 30 years, 7.5 percent. Your client refinanced a loan in July 2003, for 4.5 percent over 15 years. The unused points are $1,400. ($1,500/30 years x 2 years of the loan = $100). Assuming 33 percent federal and state income tax brackets, the $1,400 tax deduction results in a $467 tax savings.

A $150,000 loan at 7.5 percent generated $11,250 in interest expense and the refinanced loan generates $6,750 in interest. The annual savings are $4,500 in interest expense. But wait. The federal and state tax bills have gone up. The reduction in interest rate increases federal and state taxes by $1,485 if your client is in the 33 percent federal and state tax bracket. To avoid this tax surprise, be sure your client has increased his withholding for federal and state taxes by $124 each month.

Investing in a Roth IRA
The client can take the freed-up cash and invest it in a Roth IRA. A Roth IRA is made with after-tax dollars today. The earnings grow tax-free and remain tax-free when withdrawn, when the contributions remain invested for five years and the client has attained the age of 59 1/2. Early distributions are allowed if the client or spouse dies or is disabled. The maximum contribution is phased out for joint filers earning between $150,000 and $160,000 annually ($95,000 to $110,000 annually for single filers). Currently, clients age 50 or over can increase their contributions by $500 to $3,500.

Clients benefit by refinancing their homes and investing the excess cash in a Roth IRA. The cash savings generated by the lower mortgage payment pay off handsomely in the form of lower interest costs and savings for retirement.

Pam Feely is a certified public accountant in Golden, Colo. Her practice assists clients with evaluating various types of investments. She can be reached at Feely2201@aol.com.

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