Q: I have heard that the points you pay when you borrow mortgage money are not always deductible. Can you advise on the tax issues relating to the payment of mortgage loan points?

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

In the good old days, when you borrowed from a mortgage lender, you were quoted an interest rate, and that was all you paid. For example, if you borrowed $50,000, at settlement you received a check (payable to your title attorney) in the amount of $50,000 and your monthly mortgage payments began shortly thereafter.

When interest rates started to fluctuate significantly in the early 1970s, and when these interest rates started to hit the various statutory usury ceilings, mortgage lenders started to charge borrowers additional cash, which they had to pay up front to obtain the necessary mortgage funds. Although this column will not get into the complex legal question of whether the points which are paid should be included in the overall interest rate computation, the fact remains that by the mid-1970s, points were a significant -- and essential -- aspect of all mortgage loans.

Over-simplified, a point can be calculated as one percent of the loan. Thus, if you borrow $50,000, each point is $500.

Borrowers will often hear a lender say that the point structure is "two and one." This means that the lender will charge the borrower two points and charge the seller one point for the privilege of making a new mortgage loan.

On a $50,000 loan, a "two and one" point schedule means that the lender will receive $1,500 cash up front when you go to settlement.

Generally speaking, unless there are prohibitions on the number of points that a borrower can pay (such as with a VA loan), the an negotiate with the seller as to who will pay the points. Often, if sellers get the price they want, they may be willing to pick up all or a portion of these mortgage points.

Buyers and sellers of real estate should anticipate the payment of points when they are negotiating a real estate sales contract. The decision of who pays the points must be included in this contract so as to avoid future headaches and uncertainty.

All too often, I have seen sellers learn for the first time at settlement that they are obligated to pay a point or two when they sell their house. They ask the legitimate question: Why do I have to pay money to my buyer's lender?

Generally speaking, points are deductible in the year they are paid. The Internal Revenue Service takes the position that points on a home mortgage are deductible only if they are generally charged in the geographical area where the loan is made, and to the extent of the number of points generally charged in that area for a home loan. (For instance, if four points is the going rate in your area, and you claim seven, the IRS might object.)

Currently, points are being charged in the Washington metropolitan area. With the crazy fluctuations in the marketplace over the past two years, it is safe to say that any legitimate number of points charged by the lender can be deductible. It should be pointed out, however, that as interest rates have started to drop, the point structure today ranges between two and four points.

A mortgage lender handles the issue of points in one of two ways. Let us take this example. You're buying a house for $100,000, and are borrowing $80,000 from your lender. The lender is going to charge the buyer two points -- or $1,600 at settlement. The lender can either send a gross check of $80,000 to the title attorney conducting the settlement with instructions that the borrower pay the $1,600 back to the lender or the lender can deduct the $1,600 from the loan proceeds and send the title attorney a net check of $78,400.

A case decided recently by the tax court has thrown a monkey wrench into the issue of the deductibility of these mortgage points. The case (Schubel, 77 T.C. 51) held that when points are subtracted from loan proceeds by the lender, (i.e., the lender gives a net check at settlement), these points are not deductible.

According to the tax court, the taxpayer-home buyer received only the face amount of the loan reduced by the points. The tax court took the position that the borrower has not paid interest since the loan transaction is structured so that the loan fee is withheld from the lender. According to the tax court, his principal was based on economic realities. The loan may never be repaid. Thus, the court said the taxpayer has parted with nothing more than a promise to pay.

This opinion, to the layman, makes no sense. It should not make a difference to the taxpayer whether the proceeds are deducted from the loan or whether a separate check is written at settlement. The bottom line is that taxpayer-home buyers pay the points at settlement from their own pockets.

The tax court, however, has spoken. Borrowers should take precautions when they buy a house.

Here is a suggestion for future home buyers. When you make arrangements to obtain your mortgage loan, make sure that your lender will give the title attorney conducting settlement a gross check. You will write a separate check payable to the lender at settlement for the amount of the points being charged. This check will be forwarded by the title attorney to the lender shortly after settlement.

By taking this extra step, you can be assured that the points you pay at settlement will be deductible for tax purposes in the year they are paid.