Q. I have recently heard that you no longer have to pay your mortgage points by separate check to be able to deduct those points. Can you explain this situation?
A. The Internal Revenue Service recently issued a notice that effective Jan. 1, taxpayers who obtain a mortgage to buy their principal residence no longer have to write a separate check for the points for those points to be deductible.
First, let us 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 in the amount of $50,000 and your monthly mortgage payments began shortly thereafter.
However, when interest rates started to fluctuate significantly in the early 1970s and when those interest rates began to hit the various statutory usury ceilings, mortgage lenders started to charge borrowers additional cash, which had to be paid up front to obtain the necessary mortgage. By the mid-1970s, points were a significant -- and essential -- aspect of all mortgage loans. Oversimplified, a point can be calculated as 1 percent of the loan. Thus, when you borrow $50,000, each point is $500.
Borrowers will often hear a lender quote the point structure as "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 the lender will receive $1,500 cash when you go to settlement.
Generally speaking, unless there are prohibitions on the number of points that a borrower can pay, the lender does not care where these points come from. The borrower, or buyer, can negotiate with the seller as to who will pay the points. Often, if sellers obtain the price they want, they may be willing to pick up all or a portion of these mortgage points. In today's market conditions, sellers will often agree to pay all of the 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 the real estate 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 houses. They ask the legitimate question: Why do I have to pay money to my buyer's lender? The only answer to that question is that it was negotiated into the real estate contract.
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 the loan is for the purchase or improvement of your principal residence, and only if points are generally charged in the geographic 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 example, if three points is the going rate in your area, and you claim seven, the IRS will certainly object.
A mortgage lender handles the issue of points in one of two ways. Let us take this example.
You are buying a house for $200,000 and are borrowing $150,000. The lender is going to charge two points for the transaction -- or $3,000 -- at settlement. The lender can either send a check of $150,000 to the title attorney conducting the settlement with instructions that the borrower pay the $3,000 back to the lender or the lender can deduct the $3,000 from the loan proceeds and send the title attorney a net check of $147,000.
In 1981, the U.S. Tax Court threw a monkey wrench into the issue of the deductibility of these mortgage points. The ruling held that when points are subtracted from loan proceeds by the lender (for example, 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 these points. The tax court took the position that the borrower has not paid interest (points) since the loan transaction is structured so that the loan fee is withheld from the lender. According to the tax court, this principle was based on economic realities. The loan may never be repaid, and thus the court said that the taxpayer has parted with nothing more than a promise to pay.
Since 1981 the tax court has spoken, and to get around this situation borrowers were always advised that they have to write a separate check for the points at closing, to demonstrate that they in fact had paid the points separately.
On Nov. 9, the Internal Revenue Service changed the rules, effective Jan. 1.
Thus, the IRS has now put to rest the confusing question of whether points have to be paid separately, and whether they are deductible.
As long as the lender charges points, and the amounts conform to an established business practice of charging points in the area in which the loan is issued and do not exceed the amount generally charged in the area, points are deductible, even though the lender may have given the settlement attorney a net check.
The IRS made it quite clear that this relates exclusively to the purchase of a principal residence, leaving the issue of refinancing and home improvements to be determined on a factual, case-by-case basis.
Accordingly, beginning Jan. 1, the home buyer who obtains a mortgage to buy a principal residence will no longer have to write a separate check in order to obtain the benefit of the deductibility of these mortgage points.
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.