Interest and Points Create Potent Tax Breaks for Homeowners

Washngton Post, January 14, 2006
By Benny L. Kass

Among the biggest tax breaks available to U.S. homeowners is the deductibility of mortgage interest and points. Here's a review of these money-savers.

Mortgage Interest

Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married but file separately, the limits are split in half.

Lenders who receive interest payments of $600 or more from a borrower in any one calendar year must file an information return with the Internal Revenue Service stating the amount of interest received. A copy of this return, Form 1098, must also be sent to the person who paid the interest.

During the month of January, homeowners will receive this form. For taxpayers who itemize, it's a big help in filling out the forms needed to take the appropriate mortgage interest deduction.

To be eligible for the tax deduction, the debt must be secured. This means that there must be a deed of trust that is recorded among land records against your house. If the loan is not secured, you cannot deduct the interest you pay.

I often run across this situation: Parents want to help their children purchase a house and lend them the down payment. The children are required to repay the loan over a period of years, with interest. If the parents will secure the loan (i.e., record the legal document), the children can deduct the mortgage interest. Otherwise, the payments are considered personal interest, which cannot be claimed as a deduction under current law.

Points

Lenders have different terms for points, such as loan discounts or origination fees. But no matter the name, points are money the borrower must pay. Lenders can charge as many points as they can get away with, 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. Those of us who can remember back to the early 1990s know that houses can decrease 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.

Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. It used to be that the IRS required the borrower to write a separate check to the lender for these points; in recent years, the IRS seems to have backed off this position. However, it still makes sense either to write a separate check at closing or at least to 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, in most circumstances those points can not be deducted 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 deduct one-thirtieth of the points each year, or $166.67. However, if you pay off this loan early, 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.

Talk to your potential lenders about trading interest rates for points. Generally speaking, each point that you pay is the equivalent of one-eighth of a percentage point in interest. Thus, you may be able to get a loan at 6 1/8 percent with no points, but a 6 percent rate by paying one point.

Seller-Paid Points

Often, a potential buyer presents a sales contract to a seller, and asks the seller to help financially in some way to seal the deal. Such concessions can include the seller paying some or all of the buyer's closing costs, the seller giving a cash credit at settlement or the seller paying some or all of the buyer's points.

For many years, the Internal Revenue Service prohibited buyers from deducting seller-paid points. In a complete about-face, however, in 1994 the IRS ruled that purchasers could generally deduct points required by mortgage lenders, even if those points were paid by the seller.

Say you will pay $300,000 for your new house and obtain a loan of $250,000. The lender can give you lower interest if you pay two points, or $5,000. If you can convince your seller to pay this -- and have your sales contract reflect that the seller is paying this money as points -- you should be able to fully deduct this $5,000 from your income tax that you file for the year of the purchase.

The HUD-1 settlement sheet should also reflect that the seller paid the points. This document is perhaps the most important piece of paper you receive at settlement. Keep it forever, because it will be your best proof if you are ever challenged by the IRS.

There is one drawback to the deductibility of seller-paid points. The amount will be used to reduce the purchaser's basis price if those points are deducted. In our example, if the purchaser paid $300,000 for the property and deducts the $5,000 of seller-paid points, the cost basis to the purchaser is reduced to $295,000. This comes into play when determining tax liability after a house is sold. However, current tax law allows generous tax breaks when a house is sold.

Next Saturday: Tax treatment of profit from home sales.