Fourth in a series of articles
A point by any other name is still a point. But whether it can be deducted on your income tax return depends on how and when you paid it.
And while the interest you pay on most home equity loans is deductible, there are circumstances that could preclude your claiming these deductions. This column will address both issues.
When you are shopping for a mortgage loan, whether it be for a purchase of a house or a refinance, do not compare solely on the interest rate quoted by the lender. Make sure you ask whether you will have to pay any points at settlement.
In recent months, it appears that mortgage lenders have not been charging points as often as they have in the past. However, you want to be aware of all terms and conditions before you commit yourself to a lender.
Points are often called by different names, such as "loan discounts" or "origination fees." Regardless of their name, they represent money that you, the borrower, will be required to pay to get your mortgage loan. And the payment is usually upfront, in cash, at settlement.
Each point you pay is equal to 1 percent of the mortgage loan amount. Thus, one 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 can represent what is commonly known as "loan sharking" or "predatory lending."
Lenders have to take risks. They are giving money to someone who may or may not be able to pay back the loan 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. 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. But many consumers do not shop around to get the best mortgage deal; they accept the lender's statements on blind faith. It may be possible to get a better interest rate, or fewer points, from another lender.
Points paid on a mortgage to buy a house (or to pay for improvements on your property) are fully deductible in the year they are paid by the borrower.
The IRS used to require that the borrower write a separate check to the lender for these points. In recent years, however, the IRS seems to have backed away from this position. However, it still makes sense either to write a separate check at closing, or at least to have the settlement statement, the HUD-1, clearly reflect the number and amount of points you are paying.
If you pay points to obtain a refinance loan, they are not deductible in full for 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 $175,000 loan. To get a favorable rate, you agree to pay one point, or $1,750. If your loan is for 30 years, you can deduct only one-thirtieth of the points each year, or $58.33. 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.
If the purpose of the refinance loan is to pull out some money to make improvements to your house, then the portion of the points attributable to the improvement money can be deducted in the year it is paid. The balance of the points has to be spread out over the life of the loan.
Lenders are often willing to trade points for lower interest rates. Generally speaking, each point you pay is roughly the equivalent of one-eighth of a percentage point on the interest rate. Thus, you may be able to get a loan at 6 percent with no points, but a 5.875 interest rate by paying one point.
If you plan to keep the loan for a long time, it might make sense to pay that point (or points) upfront. But first you should "do the numbers" to determine where the break-even point will be. To do this, compare the monthly payment for both interest rates. Take the difference between these two rates and divide that number into the dollar amount of points you pay. The result is the number of months it will take you to break even -- after which you are ahead of the game.
If you plan to purchase a house, keep this in mind: Everything in real estate is negotiable. Often, a potential buyer submits a sales contract to a seller and asks the seller to make certain financial concessions to make the sale go through. Such concessions could 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 did not allow seller-paid points to be deducted by the purchaser. In a complete about-face, however, in 1994 the IRS ruled that these points could be deducted by the buyer. For principal residences purchased after Dec. 31, 1990, buyers could deduct points required by mortgage lenders, even if those points were paid by the seller.
Let's look at an example. You will pay $200,000 for your new house and obtain an 80 percent loan in the amount of $160,000. The lender can give you a fixed, 30-year conventional loan for 6 percent, with no points, or 5.875 percent with one point, equal to $1,600. If you can convince your seller to pay this $1,600 -- and have your sales contract reflect that the seller is paying this money as points -- you should be able to fully deduct this $1,600 on your income tax that you file for the year of the purchase. (The seller can't deduct the points; instead, he treats them as a selling expense that reduces his profit.)
Remember: The HUD-1 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.
Home Equity Loans
Many banks are prepared to lend a homeowner additional money, called a home equity loan, which is a second trust on your property.
Say the house you bought several years ago for $175,000 is now appraised at $200,000. Your current mortgage is $150,000. You want to pull out some cash for personal purposes.
You have two choices. You could refinance and probably borrow up to 80 percent of the current market value of the property, or $160,000. After paying off your existing mortgage and paying new closing costs, you will probably walk away with a check for about $9,000.
Alternatively, you could obtain a home equity loan or home equity line of credit. The loan is usually for a fixed amount and paid back over a fixed period. The line of credit is a maximum up to which you can borrow -- sort of like a credit card, but secured by your house.
The tax laws allow you to deduct interest on either type of home equity loan up to $100,000. If you are able to borrow more than $100,000, you can deduct only the interest you pay on the first $100,000. The rest of the interest is considered personal and not deductible.
One day, our tax laws may be simplified. In the meantime, to make sure you take advantage of every available deduction, read as many tax advice books as you can, search the Internet -- especially the IRS Web site, www.irs.gov -- and consult with your own tax advisers.
Next: Like-kind, or Starker, exchanges.
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. Readers may also send questions to him at that address.