Mortgage points often can be deducted

Healthcare Financial Management, Dec, 1990 by William G. Kistner

Mortgage points often can be deducted

In paying off a bank loan used to purchase a home, a borrower pays certain charges for using the money. These charges are mortgage points and quality with the Internal Revenue Services (IRS) as prepayment of interest.

Borrowers prepay interest expenses to obtain a lower stated rate of interest on a mortgage loan. A taxpayer can deduct prepaid interest ratably over the life of a mortgage.

Lenders also charge fees for specific services and other expenses incurred for a mortgage loan, such as commissions and settlement fees. Because the IRS does not classify these charges as amounts paid for using the money or as prepayments of interest, they are not deductible as points at any time. Instead, they are capitalizable items and become part of the cost of a residence.

Full deduction

An exception exists in deducting points ratably over the life of a mortgage loan. Points paid by a borrower may be deducted fully during the year paid when a loan is taken out to purchase or improve a principal residence and when the loan is secured by that principal residence. If an individual has more than one residence, the principal residence is the one lived in most of the year.

Several criteria must be met for a full deduction to be allowed. First, points must be paid with separate funds--funds not received from the lender.

Payment of points also must be an established practice in the geographical location where the loan is obtained, and points paid by the borrower cannot be greater than normal charges in that area. Otherwise, a deduction allowed in the year a borrower pays points will be limited to an area's normal charges. The amount paid beyond the area norm for points then would be deducted ratably over the life of the mortgage.

Finally, a loan for the purchase or improvement of a principal residence must be secured by the same residence.

Refinancing

The IRS position on points paid to refinance an existing home mortgage loan in repayment of the previous debt (and not to purchase or improve the principal residence) is that these points are not deductible in the year paid. In the case Huntsman v. Commissioner, however, the 8th Circuit Federal Court recently reversed a decision that had upheld the IRS position. When a taxpayer is refinancing a short-term loan secured by a mortgage into a long-term financing arrangement, the Court held, points paid qualify as deductions in the year paid, as long as the situation meets the criteria previously discussed.

In that case, the plaintiffs had purchased a principal residence in 1981. They financed the purchased by obtaining a $122,000 three-year loan with a "balloon" payment secured by a mortgage on their home. In July 1982, they obtained a $22,000 home improvement loan secured by a second mortgage on their home.

In September 1983, the plaintiffs obtained a permanent mortgage on their home, a $148,000 30-year variable rate mortgage and paid off the earlier loans with proceeds from the new loan.

In obtaining the new mortgage loan, the plaintiffs paid $4,440 in points that they deducted in full on their 1983 personal income tax return. The short-term loan was used as temporary financing until a long-term permanent mortgage loan could be obtained to complete the purchase of the taxpayer's permanent residence.

Refinancing an existing home mortgage loan usually does not qualify for the exception, and points paid must be deducted ratably over the period of the loan. The IRS feels that refinancing is generally done to achieve some financial savings, rather than for purchasing or improving a principal residence.

In the Huntsman case, this was not tre. The taxpayer acquired a refinancing loan to complete the purchase of a permanent residence. The short-term loan was an intermediate step in purchasing a principal residence with a loan secured by that residence and, as a result, qualifies for the exception.

Interest in the form of points paid by a borrower to purchase or improve a home usually is deductible. Facts of a situation must be examined to determine the timing of an allowable deduction. Sound planning in the purchase of a principal residence can give a taxpayer the choice of deducting points either in the year paid or ratably over the life of the mortgage.

Individuals with a situation similar to the Huntsmans' who did not deduct their mortgage points should consider filing an amended income tax return to obtain a refund.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Ill. Reader's comments and questions are encouraged and can be addressed to: William G. Kistner, CPA, Ernst & Young, 150 S. Wacker Dr., Chicago, IL 60606