Last week we gave a general overview of the tax deductions that are available to most home buyers. One of those deductions, that for points, is very complex and deserves more attention.

When you obtain a home mortgage, whether for a home purchase or a refinancing, a lender often will charge you points. These points can be called by different names, such as loan discounts or origination fees. The payment is usually upfront, in cash, since it generally is not included in the loan amount.

Each point that you pay is equal to 1 percent of the mortgage loan amount. Thus, 1 point on a loan of $175,000 is $1,750. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and the process may become what is commonly known as "loan sharking."

Lenders have to take risks. They are lending money to strangers, who may or may not be able to pay them back in full. To secure repayment, the lender requires the borrower to sign a deed of trust (the mortgage document), whereby the house is put up as collateral (security) to guarantee full payment of the loan. But houses can and have decreased in value, which makes the lender's security potentially more risky.

The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge.

Depending on the deal you negotiate, either the buyer or the seller may pay the points. The Internal Revenue Service treats these two situations slightly differently.

Buyer-Paid Points

Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS used to require the borrower to write a separate check to the lender for these points; in recent years, the IRS seems to have backed off this position. It still makes sense, however, to either write a separate check at closing or to make sure that the settlement statement (known as a HUD-1 form) clearly reflects the number and amount of points you are paying.

If you pay points to refinance a loan, generally they 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 mortgage loan. For example, you refinance and obtain a $200,000 loan. To get this new loan, you are required to pay 2 points, or $4,000. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year, or $133.33. However, if you pay off this loan early, say in five years, the balance of the unallocated (nondeducted) points can then be deducted on your income tax return for that year.

Many people trade off points for interest rates. Generally speaking, each point that you pay is the equivalent of one-eighth of a percentage point in interest. Thus, you may be able to get a loan at 8 percent with no points, but a 7 7/8 interest rate with 1 point.

If you plan to keep the loan for a long time, it might make sense to pay that point (or points) upfront. But you have to do the numbers to determine the break-even point. To do this, compare the monthly payment for both interest rates. Take the difference between these two rates and divide that number into the amount of points you pay. The result is the number of months it will take you to break even.

Let's take this example. Say the difference between the two interest rates is $125 per month, and you have to pay $4,000 in points to get the lower rate. Divide $4,000 by 125 and you get 32; thus, in 32 months you will break even. After that, you will start saving $125 per month in your mortgage payment.

Seller-Paid Points

Everything in real estate is negotiable. Often, the potential buyer presents a sales contract to a seller and asks the seller to make certain financial concessions to make the sale go through. Such concessions can include the seller giving a cash credit at settlement, the seller paying some or all of the buyer's closing costs, or the seller paying some or all of the buyer's points.

For many years, the IRS prohibited the buyer from deducting seller-paid points. In a complete about-face, however, the IRS ruled in 1994 that these points could now be deducted by the buyer. The IRS announced that for principal residences bought after Dec. 31, 1990, buyers could deduct, under certain circumstances, points required by mortgage lenders, even if those points were paid by the seller. This is generally referred to as "seller-paid points."

For example: You pay $250,000 for your new house and obtain a loan of $200,000. The lender can give you a fixed 30-year conventional loan for 8 percent, with no points, or 7 3/4 percent with 2 points, or $4,000. If you can convince your seller to pay this $4,000--and have your sales contract reflect that the seller is paying this money as points--you should be able to fully deduct this $4,000 from your income tax that you file for this year.

The settlement sheet is perhaps the most important document received at settlement, and should be kept forever. This will be your best proof if you are ever challenged by the IRS.

There is one major hitch to this IRS rule. The amount of the points paid by the seller will be used to reduce the buyer's basis price if the buyer now deducts those seller-paid points. The basis price is one number used to determine how much--potentially taxable--profit comes from the eventual sale of a house.

In our example, if the buyer paid $250,000 for the property and now deducts the $4,000 of seller-paid points, the cost basis to the buyer is reduced by the amount of the points deducted. In our example, the basis will now be $246,000 ($250,000 minus $4,000).

Here, however, the current tax law, which will be discussed next in this series, may come into play. Under the Taxpayer Relief Act of 1997, taxpayers 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. This exclusion can be taken once every two years; the old once-in-a-lifetime exclusion has been eliminated.

Thus, now the taxpayer's tax basis of his principal residence is relatively unimportant--unless the profit exceeds $250,000 or $500,000. In our example, if you sell your house several years later for $400,000, your gain of $154,000--even taking into consideration the $4,000 reduction in basis--will still be less than $250,000. If you have lived in this home for at least two years, all of your profit is tax-free.

Next: Profit exclusions when selling real estate

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.