You are correct in that you have to pay tax on that refund, since it was deducted from a prior year's return. This is not common, so that's why TurboTax does not deal with it in the Mortgage Interest section of the program.
To enter this income and therefore "account" for it, under the Personal Income tab scroll all the way to the bottom and elect to start/update Miscellaneous Income, 1099-A, 1099-C.
Then select Reimbursed Deductions from a Prior Year.
Select Other Itemized Deductions and click Continue.
Then enter the amount from box 4. If this is a joint return, enter it for the person whose social security number is on that 1098.
That should do ya.
