Q: Q In the Jan. 27 column you said that if you use the proceeds of refinancing a mortgage to "improve" your residence, then the points are deductible as interest in the current year; but if the proceeds are used for investment or for a child's college education, then the points may be deducted but must be spread over the life of the mortgage. I am about to refinance the mortgage on my home, not to obtain any cash but simply to "improve" my interest rate. Are the points I am about to pay deductible in the current year?
A: I received a number of letters after that column, of which this is representative. The IRS has restated its rule on this question, and fortunately their restatement supports what I said earlier.
If you refinance your present mortgage and use the proceeds to improve your home -- install a swimming pool, add a room, replace a kitchen -- then any points paid for the refinancing are deductible in the current year.
If you use the funds for any other purpose -- or for no particular purpose, but are refinancing to obtain a lower interest rate -- the points must be "capitalized" and deducted over the life of the mortgage.
In the event that you use a part of the proceeds for improvements and bank the rest, then what you may deduct is determined by applying to the total points the ratio that the improvement cost bears to the total proceeds.
Washington Post staff writer Jane Seaberry had an excellent news story on this subject in the Business Section Thursday, May 15.
This expansion of the earlier column gives me an opportunity to respond to another reader's question on a related subject. Points associated with a VA mortgage may never be deducted as interest, but should be added to the cost basis of the home for gain or loss purposes on a later sale. This restriction does not apply to FHA loans, which are handled in accordance with the general rules.
Q: My wife and I have just sold a piece of lake property (not our principal residence) for $65,000. We will receive $15,000 cash with the balance to be paid over the next 10 years, plus interest at 10 percent a year. Our net profit will be around $10,800. What is the best way to report the profit, from an income-tax point of view? Must we report the total profit in 1986? Or can we delay reporting until our original costs have been recovered? We realize that interest on the note must be paid in the year earned.
A: You are not required to report the entire profit in the year of sale; but you may not wait to report any profit until you have recovered your cost. In the absence of any special circumstances, you should use the installment sale method for reporting the profit from the sale. (As you pointed out, the interest on the note is reportable annually as interest income on Schedule B.)
To report an installment sale you use IRS Form 6252. For the year of the sale, you should answer questions A through E at the top of the form, then complete Parts I and II. In succeeding years Part I is not required. The part of the year's payments representing a proportional share of the taxable profit is then carried to Schedule D, Capital Gains and Losses (Line 11 on the 1985 form).
This technique permits you to report -- and pay tax on -- only that portion of the profit that is received each year. Using your numbers, the profit ratio works out to 16.6 percent (10,800 divided by 65,000). Thus the amount of profit included in the $15,000 is $2,490 (15,000 times 0.166) -- and that is the amount that would go on Schedule D.
If you receive additional payments on the note in 1986, you will have to add those (principal only) to the $15,000 to get the total received during the year, then multiply that total by the 0.166 figure.
Since you owned the property for more than the required six months, only 40 percent of the profit would actually be subject to tax. But if major tax legislation is passed this year, please don't hold me to the above numbers; this exercise is based on the present tax rules.