Good tax planning begins at home - mortgages and home loan points

Black Enterprise, Sept, 1994 by Patricia M. Carey

If you're like most Americans, your home is more than your castle. It's your single biggest tax break--thanks to the Internal Revenue Service deduction for home mortgage interest. It may also be an important source of cash, with home equity being used to finance everything from cars to college educations.

Over the last two years, borrowing consumers, attracted by lower interest rates, have stepped up new home buying, mortgage refinancings and home equity loans. If you're one of these people--or you're planning to buy or refinance soon--be aware of certain factors when formulating your tax planning process for next year. For example, if you're paying a lower interest rate than you were before, your interest deduction will shrink, which could translate to a bigger tax bill. As always, experts say, careful advance planning will minimize nasty surprises next April.

One area that seems to confuse a lot of people is the tax treatment of points, or prepaid interest, says Michael Van Den Akker, a tax partner in Price Waterhouse's San Francisco office. "Some people who refinance think the points are deductible up front, but that's not the case," says Van Den Akker.

The basic rules are simple: When you buy a home, points are fully deductible in the year of purchase. When you refinance, you must capitalize the points and amortize them over the life of the loan. However, if you pay off the loan early--say, by refinancing again--you can deduct the remaining unamortized points that year.

Consider this example: Suppose you refinanced your $100,000 mortgage in 1992 for a term of 30 years, paying two points, or $2,000, up front. Then in early 1993, when interest rates fell even lower, you refinanced again, paying off the earlier loan and paying three points, or $3,000, for the new loan. (For simplicity's sake, we'll assume the principal on your second refinancing was also for $100,000.)

Which points could you deduct and when? On your 1992 tax return, you could deduct just 1/30 of the points on the first refinancing, or $66. On your 1993 tax return, you could deduct the remainder of the points on the earlier loan ($2,000 - $66 = $1,934) plus 1/30 of the points on the new loan ($3,000 x 1/30 = $100) for a total of $2,034. For the rest of the life of the new loan, you can deduct 1/30 of the points or $100 annually.

Here's another twist to the points story. If you purchased a home after December 31, 1990, and the seller paid some of the points, you could be eligible for a tax windfall. Under a new IRS rule, seller-paid points--an increasingly common buying incentive in slow real estate markets--are now deductible by the buyer. Formerly, only points actually paid by the buyer were deductible.

If you received seller-paid points in 1991, 1992 or 1993, you can file an amended return for the year you bought the house. Use form 1040X and write "seller-paid points" in the top upper right-hand corner of the form. Don't forget the three-year statute of limitations on income tax filings. You have only until April 15, 1995 to amend your 1991 tax return.

Louis G. Hutt Jr., managing partner of Bennett Hutt & Co., a CPA firm in Columbia, Maryland, says at least 40% of his clients who bought homes in the past three years had some seller-paid points and are now filing for tax refunds averaging between $300 and $500. For example, if you're in the 36% tax bracket, deducting $1,000 in seller-paid points would yield a $360 refund.

One caveat: The IRS now takes the position that sellerpaid points are actually an adjustment to the price of the house. That means you have to subtract the dollar value of the points from the house price to determine your taxable obligation.

Another area of confusion concerns how much mortgage interest you may deduct. Not all mortgage interest is created equal--or tax deductible. The IRS divides mortgage debt into two categories: (1) acquisition debt, which is debt used to purchase or substantially improve your home, and (2) home equity debt, defined as debt secured by your residence but used for some other purpose. You may deduct interest on acquisition debt up to $1 million. In addition, you may deduct interest on home equity debt up to $100,000 or the fair market value of the house, minus the acquisition debt, whichever is less.

In most cases, $100,000 is the relevant figure because banks will not knowingly lend you more money than your house is worth. However, the fair market value equation can kick in if your home is heavily mortgaged and you live in an area where values are declining.