Q. I have received conflicting advice as to whether points I pay at settlement are deductible. Some advisers have indicated that they are categorically deductible, and others that there are some limitations on the ability to deduct those points. This especially is true in a refinance situation, and your advice is requested.

A. Unfortunately, I cannot give you a definite answer, but I'll attempt to highlight the law. The Internal Revenue Service and the tax courts are the only ones that can give you a definitive answer.

For a number of years, lenders have been charging "points" when a borrower obtains a mortgage (deed of trust) loan. These points -- often called loan-processing fees, discounts or premium charges -- are a means of raising the yield to the lender. Generally speaking, each point is the equivalent of 1 percent of the loan. Thus, if you borrow $100,000, each point will be $1,000.

Lenders often quote points by saying that you will be charged "two and one." This means that the lender wants three points -- and does not care whether these points are paid by the borrower/buyer, the seller or a combination. Unfortunately, when you refinance, you also have to pay points, and in this instance, because there is no seller on the other side, you will have to pay all of those points yourself.

Oversimplified, a point -- if it is to be considered an interest deduction -- must be treated as a prepayment of interest. In 1976, when Congress enacted a major tax reform act, it significantly limited the ability of taxpayers to deduct, up front, certain prepaid interest expenses. There was one notable exception -- points paid in connection with residential real estate.

The specific section of the IRS Code states that the limitation on interest deductions: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 resident of the taxpayer to the extent that . . . 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.

Thus, the U.S. Congress made it clear that points are deductible as prepaid interest in the year they are paid, under certain circumstances. According to the committee report issued by Congress to explain the tax reform act of 1976, "points are additional interest charges which are usually paid when a loan is closed and which are generally imposed by the lender in lieu of a higher interest rate. When points are paid as compensation for the used borrowed money and thus qualify as interest for tax purposes rather than as payment for the lender's services, the points substitute for a higher stated interest rate. As such, points are similar to a prepayment of interest . . . are to be treated as paid over the term of the loan. This rule also applies to charges similar to points, whether called a loan-processing fee or a premium charge."

So, there are three basic limitations to the deductibility of points: 1. If the borrower incurs indebtedness in connection with the purchase or improvement of his principal residence, and that indebtedness is secured by a deed of trust on that residence, the points can be deductible. If, on the other hand, the points are used for purposes other than purchasing or improving the taxpayer's principal residence, the points are not deductible.

For new homeowners, clearly they are "purchasing" their principal residence, and points paid in connection with any mortgage loan are deductible. But when you refinance, if you read the tax code narrowly, the funds must be used for the "improvement" of that principal residence. Unfortunately (or perhaps it would be better to say fortunately), neither Congress nor the courts have set guidelines for the word "improvement." Thus, if you are satisfied in your own mind that all or even a portion of your refinance proceeds will be used for the improvement of your house, the tax code permits you to deduct your points. 2. The points must reflect the established business practice in the geographical area where the loan is made. Because lenders in the Washington area charge points, you meet this test if you pay points. 3. The deduction may not exceed the number of points charged in your area for this type of transaction. Thus, for example, if the amount of points charged in your area is three, and if you try to buy down the interest rate by paying six or seven points, the IRS could argue that only the three points are deductible this year. The remaining points must be capitalized -- which means you can deduct these as interest but that you must spread them over the life of your loan.

And recently, the tax court held that points -- to be deductible -- must be paid separately when you obtain your mortgage loan.

This may not answer your question. But recently, a U.S. Supreme Court justice observed that when it comes to income taxes, any legitimate and creative means of obtaining deductions will be permitted.

Thus, the ability to deduct your points depends on your creativity and, of course, your conscience.