Interest paid on the refinanced loan may qualify for tax relief

With falling interest rates on mortgage, many borrowers find that they are paying quite high rates in comparison. Sometimes the difference between the existing rates for new loans and the old rates they borrowed can reach 200 basis points or 2% or even more. These borrowers are therefore tempted to take out new loans at lower interest rates to repay existing loans that carry higher interest rates. Are there tax consequences of such refinancing of existing loans?

Tax the deductibility of interest paid on loans depends on the purpose for which the loan is used. If a loan is used to buy a house, interest is deductible (up to a maximum of 2 lakh, provided that the house is not the only one whose annual value is declared exempt) in the calculation of income under the heading “income from the ownership of the house”. If the loan is used to purchase a car, the interest deductibility of this loan depends on whether the car is used for business or professional purposes, or whether it is for personal use. If it is for personal use, the interest on the car loan is not tax deductible. If the car is used for business or professional purposes, the interest on the car loan is tax deductible.

Interest on loans taken to finance children’s higher education expenses is tax deductible from total gross income. If the loan is used to purchase personal property, such as household furniture or consumer durables, or is used to finance personal expenses such as a vacation, the interest on the loan is not tax deductible. If the loan is used to purchase investments, the interest on the loan is deductible from the income from these investments (up to a limit of 20% of such income).

When you refinance an existing loan, the tax deductibility of interest depends on the purpose for which the original loan was used and whether the interest on the original loan was tax deductible. If the interest on the original loan were tax deductible, the interest on the new loan would also be tax deductible in the same way, provided that there is a direct link between borrowing from the new loan and paying off the old loan.

Within the framework of the loans taken out to buy a house, the Central Commission of Direct Taxes (CBDT) specified in a circular published in 1969. It specifies that the second loan should have been used only to repay the initial loan, and this fact should be proven to the satisfaction of the tax official. But this principle would apply equally to the refinancing of loans contracted for commercial purposes (to purchase commercial assets or for other commercial purposes) as for the purpose of acquiring investments or for other purposes.

In situations where the new lending institution directly pays the loan amount to the existing lending institution (which is normally the process), there is clearly a direct link, and it can be safely concluded that the new loan is not ‘was only used to repay the existing loan. However, in situations where the new loan is disbursed to the borrower, who then uses it to repay the existing loan, care should be taken to ensure that a direct link is maintained between receipt of the new loan and repayment of the loan. the old loan ready.

If the amount of the new loan is greater than the existing loan being repaid, the deductibility of interest on the new loan would be the same as that of interest on the existing loan to the extent of the amount used for repayment of the existing loan. The deductibility of interest on the amount of the loan balance would depend on the purpose for which this balance was used.

When you take out a new loan, there will also be a processing fee. Are these processing fees tax deductible? Under the tax law, these processing fees would also be considered as interest, and therefore would or might not be deductible in the same way as interest on the new loan.

Usually, the lending institution requires the borrower to take out a life insurance policy. Often the lending institution underwrites the policy on behalf of the borrower for the term of the loan and can fund the premium through the loan. Is the interest on these funded life insurance premiums deductible? To the extent of the loan being used to finance the life insurance premium, the interest on the loan may not be tax deductible because this part of the loan is not the same as the rest of the loan.

Overall, loan refinancing is tax neutral, provided that care is taken to maintain a link between the new loan and the repayment of the existing loan.

Gautam Nayak is a chartered accountant

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