Don’t Overlook Tax Break of Mortgage Points

By: Kay Bell * Bankrate.com

If you have ever taken out a mortgage, you probably already know of the tax advantage provided by deducting your mortgage interest payments.  But many homeowners overlook another tax break available for points paid to get a home loan.  In some cases, points also could shave tax bills for folks who refinanced or got an equity loan or line of credit.

Each point is 1 percent of the loan amount.  Lenders charge points as a way to make a profit, and borrowers generally pay points in exchange for lower mortgage rates.

If you paid points, the amount should be listed on the 1098 statement from your lender.  This document also notes how much mortgage interest you paid.  Both of these deductible amounts go on line 10 of Schedule A.  (If the points aren’t on the statement, but show up elsewhere – for example, on your closing documents – enter them on line 12.  Check the Schedule A instructions for details.)

Getting the Maximum Deduction

On a conventional mortgage, usually a fixed-rate, 30-year loan that is not insured by a federal agency, points may be paid by either buyer or seller or split between them.  Even if the seller pays all the points, the buyer gets the deduction.  Exactly how much of one and when depends on the loan circumstances.

Loan points are fully deductible in the year paid if they meet all of these requirements:

• The loan is secured by your main home, the house you live in most of the time.
• Paying points is an established business practice in your area.
• The points are generally what is charged in your region.
• You use the cash method of accounting: You report income in the year you receive it and deduct expenses in the year you pay them.  Most individuals do this.
• The points are not paid in place of amounts ordinarily stated separately on the settlement sheet.  That is, you cannot pay points in exchange for lower or no appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
• The funds you come up with at or before closing, plus any points the seller pays, must be at least as much as the points charged.  The money does not have to apply just to the points.  It can include a down payment, escrow deposit o9r earnest money.  But it all must come to at least as much as the points.  For example, you took out a $100,000 mortgage and were charged $1,000 (one point).  However, your lender only required a $750 down payment.  In this case, you cannot deduct the full $1,000 points payment, only $750 of it.  The remaining $250 must be deducted over the life of the loan.  And you cannot have borrowed any of the money you paid at closing from your lender or mortgage broker.
• The loan is used to buy or build your main home.
• The points are computed as a percentage of your mortgage’s principal amount.
• The amount is clearly shown on the settlement statement as points charged for the mortgage.  The points may be shown as paid from either buyer or seller funds.

These point deductibility rules apply to loan costs associated with your primary residence.  When the loan is tied to a property that is not your main home, the points cannot be fully deducted in the year the loan was mad.  Points paid on a loan secured by a second home or vacation residence, regardless of how the cash is used, must be amortized over the life of the loan.

Refi Points

While points-deductibility definitely is a tax-saving option buyers should explore any time they get a loan to buy another home, a taxpayer who simply refinances also might be eligible for this tax break.

In most refinancing cases, a homeowner must deduct any loan points over the life of the loan.  But if part of the refinanced mortgage proceeds are used to improve the main home and tests 1 through 6 listed previously are met, the portion of points attributable to the improvement can be deducted in the year paid.  Any points related to the refinanced existing balance, however, are not eligible for immediate tax-deduction purposes; they still must be amortized over the life of the refinanced loan.  These points-deductibility rules also apply to home equity loans or home equity lines of credit.

If, however, you use your refi to get some extra cash or take out a home equity loan or line of credit and then use the money for something else, such as paying college costs or buying a car, you still can deduct the points, but not all at once.  The points deductions must be parceled out over the equity loan’s term.

To figure the annual deduction amount, divide the total points paid by the number of payments to be made over the life of the loan.  You should be able to get this information from your lender.  For example, a homeowner who paid $1500 in points on a 30-year second mortgage (360 monthly payments) could deduct $4.17 per payment, or a total of $50 for 12 payments, for each tax year of the loan.

Challenging the Amortization Rule

In 2005, a California couple won a tax-court ruling against the IRS demand that refi points be paid over the life of the loan

In this case, Gary and Rebecca Hurley paid $4,400 in points to refinance their home in 1999.   The home equity funds eventually were used to make substantial home improvements.  The upgrades took several years to complete, but when the Hurleys filed their 1999 return, they deducted the total points since they knew they were going to use the loan funds toward improving their residence, as the rule states.

The IRS disagreed and instructed the couple to spread the deduction over the life of the 15-year equity loan.  The IRS’ contention: Since all the loan money was not used in the 1999 tax year for the improvements (it took the couple until 2003 to complete the house work), the immediate deduction was not allowed.

The Hurleys went to tax court.  Last September, the court agreed with the couple.  Specifically, the judge concurred that the refinancing was done, as required by tax law, “in connection with” home improvements, therefore entitling the Hurleys to deduct all of their points in the year they got the loan.

The judge also said the IRS offered no evidence that current rules require the eligible home improvements be done in the year of the refinancing.

A couple of notes here:  First, the Hurleys followed the cardinal rule of dealing with the IRS: They kept copious records detailing their deduction-related expenditures.  Secondly, and more importantly for the rest of us, the ruling sets not tax-law precedent.  The judge issued what is known as a summary opinion, a ruling that is not treated as the basis for future tax arguments.

However, the Hurleys’ persistence shows that it is possible to fight the IRS and win, as long as you go in prepared, are patient, and have the means to hire a good tax attorney.  Who knows?  Another tax court judge might just have the same point of view as the one who heard the Hurleys’ case.

Serial Refinancing

Amortizing also comes into play for serial refinances – homeowners who take repeated advantage of low mortgage rates to get better and better home loans.  This was a common practice at the housing boom’s height, but some borrowers still redo their loans more than once to get better interest rates or a different type of loan product.  The good news for most homeowners is that they don’t lose that portion of the first refi’s points that they’ve been amortizing.

The IRS says you can deduct any remaining balance of the points in the year the mortgage ends, either due to a prepayment, refinancing, foreclosure or similar event.  Say, for example, our hypothetical refinancer got his loan three years ago.  It was a 30-year loan, so he deducted $50 in points on his last three tax returns.  Now he decides to refinance again because rates are even lower.  Since the first refi is paid off via the second refi, he probably can deduct the remaining $1,350 in points on his next tax return.

But this immediate, and often large, points tax break doesn’t apply in every case.  If, for instance, the second refinancing is with the same lender, the IRS says you cannot immediately deduct any remaining balance of your first refi’s points.  Instead, the remaining points balance from the first refi is added to your new refinance amount.  You then continue to deduct them, along with any points from the second refi, for the life of the new loan.