Just about every homeowner knows that 2001 was the year of the Great Refi Boom, when millions of Americans took advantage of low interest rates to cut their monthly loan payments and pull out thousands of dollars of tax-free cash.

But guess what? The Internal Revenue Service watched the refi boom last year with (no pun intended) great interest. Although the IRS never announces or officially confirms its special targets for audit attention in advance, tax experts say IRS auditors will be looking especially hard at 2001 tax filings this year for violations of federal restrictions on home mortgage refinancing write-offs.

Among the key targets: Non-compliance with the federal tax code's confusing rules on interest deductions on refinanced mortgages. Many homeowners may assume that they can deduct interest payments on a succession of larger and larger refinancings, as long as the loan amount doesn't exceed $1.1 million -- the overall federal limit for home loan interest deductibility.

But that's incorrect. Refinancings are treated starkly differently from new loans for federal tax purposes. Under the code, you can write off interest on your "acquisition indebtedness" --your original mortgage principal balance minus the principal you've already paid off -- plus another $100,000 of "home equity" debt.

Refinancing proceeds that are used to make substantial improvements to your home count as net additions to your acquisition debt. Say you bought your house with a $200,000 mortgage in the 1990s, paid off $10,000 in principal, and later refinanced into a $275,000 loan, the proceeds of which you used for personal expenditures. Your last refi moved you within $15,000 of your interest-deductibility limit ($200,000 minus $10,000 equals $190,000. Add $100,000 for home equity debt and you've got a $290,000 cap.) Should you refinance and pull out more than $15,000, you would exceed your legal limit.

But during the hey-day of the 2001 refi boom --when industry estimates suggest that the average refinancer added an extra $40,000 to his or her existing mortgage balance -- who was thinking about abstruse matters like acquisition indebtedness? That was understandable, but in 2002 you'll need to focus on the tax implications.

Martin Nissenbaum, national director of personal tax planning for the accounting firm of Ernst & Young, says that homeowners in high-cost housing in high-appreciation markets are the most likely to run into this little-known tax snare on their 2001 returns.

Most vulnerable are refinancers in California, Massachusetts, metropolitan New York-Long Island, Connecticut, Miami-Coral Gables and Naples, Florida, plus scattered pockets of Colorado and Utah. All of these markets have high concentrations of upper-end properties, and experienced double-digit appreciation for at least a year. High-cost homes in San Jose and San Francisco saw appreciation of 50 percent or more in the past five years alone, encouraging many owners to substantially increase the size of their mortgages via multiple refinancings.

Watch out, warns Nissenbaum. Before filing your 2001 returns, make certain you are not claiming deductions on what have become mortgage balances that exceed the limit for full deductibility. Ignorance of the fine points of the law won't save you from IRS penalties after an audit.

Another key audit target: Did you claim a deduction for the "points" you paid for your 2001 refi? One point equals one percent of the loan amount. Points typically are construed as interest paid in advance under the tax code, and are only deductible in the year in which they are paid on new home purchases or home improvement financings.

Points on refinancings, however, must be written off on a year-by-year, pro-rata basis over the life of the mortgage. Generally you cannot claim them in the year you paid them. When you do finally pay off the loan, you can then write off whatever balance of the points remains.

For details regarding your specific refi situation, be certain to check with a tax professional.

For more articles by Ken Harney, please press here.

Published: January 7, 2002

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.