Housing Counsel: Tax Court Has Good News For Point Payers

Written by Posted On Sunday, 18 September 2005 17:00

A point by any other name is still a point. But whether it can be deducted on your income tax return depends on the circumstances of how and when you paid those points. A recent Tax Court decision has clarified the rules -- in favor of homeowners.

The interest that you pay on your mortgage loan is deductible, although there is a ceiling spelled out in the tax laws. Interest paid on loan amounts over $1 million can not be deducted.

In addition to mortgage interest, some lenders will charge you a point or more in order to obtain your home loan.

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 homeowner -- will be required to pay in order to get your mortgage loan. And the payment is usually up-front, in cash, at settlement.

Each point you pay is equal to one percent of the mortgage loan amount. Thus, one point on a loan of $200,000 is $2,000. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and can represent what is commonly known as "loan sharking" or "predatory lending."

Points paid on a mortgage to buy a house (or to pay for improvements you are making to the property) are fully deductible in the year they are paid by the borrower. The IRS used to require that the borrower write a separate check to the lender for these points; in recent years, however, the IRS seems to have backed away from 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, they may not be deductible in full in 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 30-year loan in the amount of $200,000. To get a favorable rate on this loan, you agree to pay one point -- or $2,000. Since your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $66.67. However, when you pay off this loan early -- say in five years -- the balance of the unallocated (nondeducted) points can then be deducted on your income tax return for that year.

If the purpose of the refinance loan is to pull out some money to make improvements to your house, then that portion of the points attributable to the improvement money can be deducted in the year it is paid. The balance of the points have to be spread out over the life of the loan.

In April of 1999, Mr. and Mrs. Gary Hurley refinanced their home in Paso Robles, California, and paid points to their lender in the amount of $4,400. They used all of the money from the refinance loan to make various improvements to their home, such as replacing their roof, kitchen and bathroom floors and a door.

When they filed their 1999 income tax return, the Hurleys deducted the entire amount of the points, but the IRS disallowed this deduction, claiming that the Hurleys had to allocate this amount over the life of their 15 year loan.

In a Summary Opinion -- which technically cannot be treated as precedent for any other case -- the Tax Court revered the IRS and allowed the deduction.

According to the Court, although points for a refinance loan -- which are considered prepaid interest -- must be amortized over the life of a loan, there is an exception "that allows a taxpayer to deduct the full amount of points paid. Under Section 461(g) of the Tax Code, there are two instances where a taxpayer may deduct the entire amount of points paid to refinance a personal residence: (1) when the taxpayer refinances in order to purchase a new home, or (2) when the refinance moneys are used to make improvements to the home."

The Hurleys presented evidence at their trial of all of their improvements. It is to be noted that although the Hurleys started their work just 9 days after they received their money, the total job was not completed until 2003 -- four years later.

Section 461(g) reads as follows:

This subsection shall not apply to points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, such payment of points is an established business practice in the area in which such indebtedness is incurred, and the amount of such payment does not exceed the amount generally charged in such area.

According to the Judge deciding the case, "The Court has never specifically addressed under what facts or circumstances section 461(g) allows a taxpayer to deduct points paid during refinancing."

However, the Judge went on to state that the words "in connection with" require a broad interpretation.

Mr. Hurley testified at his trial that they refinanced in order to "free up money to be able to do home improvements. That was the whole idea of it."

Based on this testimony -- and the facts of the Hurley situation -- the Tax Court upheld the deduction. In fact, the Judge politely chastised the IRS by stating that they "presented no authority that would require the improvements to be performed in the year of the refinancing ...." Since the refinancing was "in connection with" home improvements, the Hurleys were entitled to deduct all of their points in the year that they obtained their loan.

The Hurleys deserve the praise of all homeowners. While this opinion cannot be used as legal precedent in other cases, it certainly reflects the thinking of a tax court judge.

If you refinance your home, and use the money for improvements, you should now be able to deduct all of the points you may have paid when you file your income tax return for the year in which you obtained the loan. According to at least one judge, it makes no difference that you were unable to complete the improvements during that same year; if your loan was "in connection with home improvements," you can challenge the IRS should they reject your deductions.

What does this mean for many homeowners? Each point that you pay will reduce your loan interest rate by 1/8 of a percent. For example, you may be able to obtain a 6 percent loan with no points, but if you pay one point, your loan will be 5.875 percent (5 7/8). If you can deduct the entire amount of your points in one year (instead of having to amortize it over the life of your loan) it may be worth paying that extra point, especially if you plan to stay in your house for a long period of time.

If you plan to refinance, shop around. Ask a number of lenders what rate you can get with no points and what rate you will get if you pay one point. In fact, you may even be able to plug that point into the amount of your loan. For example, you are looking for a refinance loan of $200,000. If you pay one point, your lender may will willing to fold that amount into your loan, so that you will actually borrow $202,000 -- but at a lower mortgage interest rate. This way, you may get a double benefit -- a lower rate and not having to pay the $2,000 up front.

But do your homework and work the numbers before you commit yourself to a particular loan or a specific lender.

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Benny L Kass

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 LEGAL GROUP, 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.


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