Points on buying a house - tax aspects

Nation's Business, Sept, 1990 by Gerald W. Padwe

Points On Buying A House

In financing home purchases, lending institutions usually charge "points" to borrowers. A point equals 1 percent of the loan amount and generally is called a "loan-origination fee" or "loan-discount fee." Since points are paid at the beginning of the mortgage period and the lender can use that money for the duration of the loan, the nominal mortgage interest rate can be slightly less than otherwise would be charged.

For tax purposes, payment of points by a borrower is considered prepaid interest. Since the mortgage loan generally is secured by a principal or second residence, the amount paid as points should be fully deductible - without any of the limitations imposed on deducting personal interest.

Nonetheless, there is a tax question: When are the points deductible? A recent Circuit Court of Appeals case helps answer the question and also shows the Internal Revenue Service's tough stance against current deductibility of points.

Two taxpayers bought a principal residence in January 1981 and financed it with a three-year loan secured by the house. The loan had a large balloon payment that would come due in January 1984. In 1982, a home-improvement loan was taken out for an additional amount. In September 1983, the taxpayers obtained a traditional 30-year mortgage and used the proceeds to pay off both outstanding loans. As part of this, the taxpayers paid three points, which they deducted on their 1983 return. The IRS disallowed the deduction.

Prepaid interest is deductible, said the IRS, but only over the life of the loan. An exception to this rule allows current deductibility for points that have been paid if the loan is secured by a principal residence and the points are "in connection with the purchase or improvement of" the principal residence.

The IRS held that almost three years after the purchase and a year after the home improvements the 30-year mortgage was not "in connection with" the purchase or improvement of the home but was only to refinance the original loans; thus the points could be deducted only over the life of the mortgage.

The taxpayers appealed to the U.S. Tax Court, which upheld the IRS ruling in an 8-3 decision. However, the 8th Circuit Court of Appeals now has reversed the lower court and the IRS. In a more pragmatic reading of the words "in connection with," the appeLlate court determined the purpose of the 30-year mortgage was to provide permanent financing for the home purchase and improvements, which had been supported only by short-term loans. Therefore, the financing was very much "in connection with" the home purchase.

The appeals court decision is binding only in the 8th Circuit. Moreover, the Tax Court, by deciding 8-3 for the IRS, has shown it might still decide against a taxpayer on the same facts if an appeal is heard in a different circuit.

The above case indicates that if a longer-term mortgage has been outstanding for some years and is then refinanced to take advantage of lower current interest, any points paid on the refinancing probably would not be immediately deductible.

PHOTO : Homeowners who refinance mortgages to benefit from lower interest rates may find that "points" paid on refinanced loans are not immediately deductible.

Gerald W. Padwe is associate national tax director for professional practice for Delloitte & Touche. Readers should see tax and legal advisers on specific cases.