Counting on Tax Deductions? Be Sure to Count Them Right

For example, let's say your current mortgage balance is down to $200,000, but because of the tremendous appreciation over the past few years, your house is now worth $600,000. You would like to refinance and pull out some money.

Based on your credit and the equity in your house, your lender is prepared to lend you $450,000. That sounds great, but unless you use the money to improve the house, you will be able to deduct interest on only $300,000 -- acquisition debt of $200,000 plus $100,000 in home equity. The Internal Revenue Service has made it clear that you do not have to take out a separate home equity loan to qualify for this tax deduction. The remaining interest is treated as personal interest and is not deductible.

Points: When you shop for a mortgage loan -- which is something every potential home buyer should do -- you get a lot of information. One of the most important items you should understand is the concept of "points."

Each point is 1 percent of the amount of your mortgage loan; you pay points upfront when you borrow. Points can go by other names, such as loan discounts or origination fees, but for tax purposes, they're points.

If you were to borrow $450,000, each point would cost you $4,500. 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."

Typically, for every point you pay a lender, you should be able to reduce your interest rate by 1/8 of a percent. Because interest rates were extremely low in the past few years, borrowers generally have not wanted to pay extra cash just to get an even lower rate.

Points paid to obtain a new mortgage 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, the IRS seems to have backed off this position. However, it still makes sense 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 are not 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 loan.

For example, you refinance and obtain a loan for $450,000. To get this new loan at a reduced interest rate, you opt to pay one point, or $4,500. If your loan is for 30 years, you can deduct one-thirtieth of the point each year, or $150. However, should you pay off this loan early, either by selling your house or refinancing again, the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.

 Seller-paid points: Everything in real estate is negotiable, especially in a slow market. Often, a potential buyer presents a sales contract to a seller and asks the seller to make financial concessions so the sale will go through. Such concessions include (1) the seller paying some or all of the buyer's closing costs, (2) the seller giving a cash credit at settlement, or (3) the seller paying some or all of the buyer's points.

Believe it or not, the IRS has issued a ruling that these "seller-paid points" can be deducted by the purchaser rather than the seller under certain circumstances.

Here's another example. You will pay $450,000 for your new house and obtain a loan of $360,000. The lender can give you a fixed 30-year conventional loan for 6.5 percent, with no points, or 6.25 percent if you pay two points, or $7,200. If you can convince your seller to pay this sum -- and have your sales contract reflect that the seller is paying this money as points -- you should be able to fully deduct the entire payment from your income tax for this year.

The settlement sheet is perhaps the most important document you will receive at settlement, and you should keep it forever, even if you sell the house. It will be your best proof if you are ever challenged by the IRS.

There is one major hitch to deducting seller-paid points. The amount of the points paid by the seller will be used to reduce the purchaser's basis price if the purchaser deducts them. The basis comes into play when you sell the house.

In our example, if the purchaser paid $450,000 for the property and now deducts the $7,200 of seller-paid points, the cost basis to the purchaser is reduced by the amount of the points deducted. The basis will now be $442,800 ($450,000 minus $7,200).

Under current tax law, this may not be a real problem for you, because taxpayers who own and live in their house for at least two years can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence. Thus, the tax basis is relatively unimportant unless your profit exceeds those levels. I'll discuss this in more depth in next week's column.

Next Saturday: Tax implications of selling your house.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.