Question: Last year, we took advantage of the lower mortgage interest rates and refinanced our home. This was the second time in three years that we have refinanced. After shopping around for the best rate and terms, we decided to stick with our current lender for the new loan. When we refinanced the first time -- two years ago -- we paid one point and were advised by our accountant that we could not deduct that point in full, but would have to spread it over the 30-year life of the loan. However, at that time, we were also advised that if we sold our home -- or refinanced again -- the balance of the nondeductible points could be deducted in full.

We recently have been advised that this is no longer the case, and that we cannot deduct the remainder of the points on our 2003 income tax return. Can you clarify this?

Answer: According to the current position of the Internal Revenue Service, you cannot deduct the balance of those points if you refinance through the same lender. I do not believe the IRS is correct, but I don't audit your tax return. So the decision is yours to make.

First, let's explain what "points" are.

When you shop for a mortgage loan -- which is something every potential homebuyer should do -- you will be given a lot of information. One item which you must understand is the concept of "points."

Points are often called by different names -- such as loan discounts or origination fees -- but regardless of their name, they represent money which you -- the consumer -- must pay. And the payment is usually up-front, in cash, since it generally is not included in the loan amount.

One point is equal to one percent of the mortgage loan amount. Thus, one point on a loan of $250,000 will cost you $2,500. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and may represent what is commonly known as "loan sharking."

Lenders take risks. They lend money to a stranger, who may or may not be able to repay the loan in full. To secure repayment of the loan, the lender requires the borrower to sign a deed of trust (the mortgage document) whereby the house is put up as collateral (security) to guarantee full payment of the loan. But houses can (and have) decreased in value, which makes the lender's security potentially more risky.

The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge. But many consumers do not shop around to get the best mortgage deal; they take the lender's statements about credit status on blind faith. It is often possible to get a better interest rate -- or less points -- from another lending source.

Points paid to obtain a mortgage to buy a house are fully deductible in the year they are paid by the borrower. It used to be that the IRS required that the borrower write a separate check to the lender for these points; in recent years, the IRS seems to have backed off of this position. However, it still makes sense to either write a separate check at closing -- or at least have the settlement statement (the HUD-1) clearly reflect the number and amount of points you are paying.

If you pay points to obtain a refinance loan, however, in most circumstances those points are not deductible in full for the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your mortgage loan. For example, you refinance and obtain a loan in the amount of $250,000. To get this new loan, you are required to pay two points -- or $5,000. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $166.67. In five years, for example, you will have deducted $833.35 ($166.67 x 5), leaving a balance of $4,166.50 in points which you have not yet deducted. If you pay off this loan at the end of five years, either by selling your house or refinancing again -- the balance of the unallocated (nondeducted) points can then be deducted on your income tax return for that year.

Or at least we used to think this was the case.

The IRS has changed its mind several times over this issue. For example, in 1983, the IRS issued a News Release reminding taxpayers that it would "disallow any deduction claimed for interest paid on a loan if the payment was made with funds obtained from the original creditor through a second loan."

According to the IRS, their position was based on several court cases which had disallowed such mortgage interest deductions. One such case was a 1981 opinion from the 9th Circuit Court of Appeals, where the court wrote:

...where the taxpayer borrows money from the same lender for the express purpose of 'satisfying' his interest obligation, that obligation, in a different form, remains the same.

Accordingly, the IRS -- back in the 1980's -- took the position that payment of interest was nothing more than a postponement of the taxpayer's interest obligation to the lender.

Over the years, however, the IRS sent signals that it would not challenge the deduction of these unallocated points paid in a refinancing if the same lender was used.

Now, however, it appears that the IRS has once again, changed its mind. In Publication 936, entitled "Home Mortgage Interest Deduction for use in preparing 2003 Returns," the IRS categorically states:

Mortgage ending early: If you spread your deduction for points over the life of the mortgage, you can deduct any remaining balance in the year the mortgage ends. However, if you refinance the mortgage with the same lender, you cannot deduct any remaining balance of spread points. Instead, deduct the remaining balance over the term of the new loan.

As indicated, I do not agree with this position. When you refinance your existing mortgage loan, for all practical purposes you are getting a new loan -- whether or not you use your current lender. The lender will require a new title search, will expect you to pay a lot of closing costs, and will treat the refinance as a brand new transaction.

More importantly, the current IRS position ignores the following situation: your current loan balance is $200,000, and you refinance with the same lender. However, instead of obtaining a new loan in the same amount, you either pull out some cash (say another $25,000) or you pay down the loan a bit and borrow only $175,000. Are these the kinds of transaction in which the IRS would allow the remaining points to be paid in full, since (in the words of the 9th Circuit) the obligation no longer remains the same?

And what about the case where the first refinance lender sold your mortgage to some other lender? If you go back to the first lender, will the IRS permit you to fully deduct the remaining points, since this is no longer the same lender.

As can be seen, there are many unanswered questions relating to this issue. What should you do? My recommendation is as follows. If you decide to refinance with the same lender, and have points from your old loan which have not yet been deducted, make sure that your new loan is not the same amount. Either borrow a few dollars more than your current obligation or borrow a few dollars less. This way, in my opinion, the mortgage obligation is not the same and you may be able to pass muster with the IRS, should they decide to audit your return.

Published: March 1, 2004

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Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.