A point by any other name is still a point. But whether it can be deducted on your income tax return depends on the circumstances of how and when you pay those points and how you use the loan proceeds. A recent U.S. Tax Court decision has clarified the rules -- in favor of homeowners.
The interest you pay on your mortgage loan is deductible, although there is a $1 million loan ceiling. In addition to mortgage interest, some lenders will charge a point or more for a home loan.
Points are often called by different names, such as loan discounts or origination fees. Whatever they are called, they represent money that you -- the borrower -- pay to get your mortgage. And the payment is usually upfront, in cash, at settlement.
Each point you pay is equal to 1 percent of the mortgage loan amount. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and can be what is commonly known as "loan-sharking" or "predatory lending".
Points paid on a mortgage to buy a house -- or to pay for improvements you are making to the property -- are fully deductible in the year they are paid by the borrower. The Internal Revenue Service used to require that the borrower write a separate check to the lender for points. In recent years, however, the IRS seems to have backed away from this position. However, it still makes sense to either write a separate check at closing, or at least have the settlement statement (the HUD-1 form) clearly reflect the number of points and amount of money you are paying.
If you pay points to obtain a refinance loan, however, they may not be deductible in full in the year they are paid. The IRS requires in many circumstances that you allocate the points by the number of years of your mortgage loan. For example: You refinance and obtain a 30-year loan of $200,000. To get a favorable rate on the loan, you agree to pay one point, or $2,000. Because your loan is for 30 years, you can deduct only one-thirtieth of the points each year, or $66.67. However, when you pay off the 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 make improvements to your house, then that portion of the points attributable to the improvement money can be deducted in the year it is paid. The balance of the points have to be spread out over the life of the loan.
In April 1999, Gary E. Hurley and his wife, Rebecca L. Hurley, refinanced their home in Paso Robles, Calif., and paid $4,400 in points to their lender. They eventually used all of the money from the loan to make improvements to their home, such as replacing their roof, kitchen and bathroom floors, and a door.
When they filed their 1999 income tax return, the Hurleys deducted the entire amount of the points, but the IRS disallowed the deduction, claiming that the Hurleys -- who took several years to complete their improvements -- had to allocate the amount over the life of their 15-year loan.
In a summary opinion -- which is not treated as precedent for any other case -- the Tax Court reversed the IRS and allowed the deduction.
According to the Court, although points for a refinance loan must be amortized over the life of a loan, there is an exception "that allows a taxpayer to deduct the full amount of points paid. Under Section 461(g) of the Tax Code, there are two instances in which a taxpayer may deduct the entire amount of points paid to refinance a personal residence: when the taxpayer refinances in order to purchase a new home, or when the money borrowed is used to make improvements to the home.
At their trial, the Hurleys presented evidence for all their improvements. It is to be noted that although the Hurleys started their work just nine days after they received their money, the job was not completed until 2003, four years later.
Section 461(g) reads as follows: "This subsection 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 residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, 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."
According to the judge deciding the case, "The Court has never specifically addressed under what facts or circumstances section 461(g) (2) allows a taxpayer to deduct points paid during refinancing." The judge went on to state that the words "in connection with" require a broad interpretation.
Gary Hurley testified at his trial that he and his wife refinanced to "free up money to be able to do home improvements. That was the whole idea of it."
Based on that testimony and the facts of the case, the Tax Court upheld the deduction. In fact, the judge politely chastised the IRS by stating that the agency "presented no authority that would require the improvements to be performed in the year of the refinancing." Since the refinancing was "in connection with" home improvements, the Hurleys were entitled to deduct all of their points in the year they obtained their loan.
The Hurleys deserve the praise of all homeowners. While this opinion cannot be used as legal precedent in other cases, it certainly reflects the thinking of a Tax Court judge.
If you refinance your home, and use the money for improvements, you should now be able to deduct all of the points you may have paid when you file your income tax return for the year in which you obtained the loan. According to at least one judge, it makes no difference that you were unable to complete the improvements during that same year; if your loan was "in connection with home improvements," you can challenge the IRS should it reject your deductions.
What does this mean for homeowners? Each point that you pay will reduce your loan interest rate by about one-eighth of a percentage point. For example, you may be able to obtain a 6 percent loan with no points, but if you pay one point, your loan rate will be 5.875 percent. If you can deduct the entire amount of your points in one year (instead of having to amortize it over the life of your loan) it may be worth paying that extra point.
If you plan to refinance, shop around. Ask a number of lenders what rate you will get with no points and what rate you will get if you pay one point. You may even be able to plug that point into the amount of your loan. For example: You are looking for a refinance loan of $200,000. If you pay one point, your lender may be willing to fold that amount into your loan, so that you actually borrow $202,000, but at a lower interest rate. That way, you may get a double benefit: a lower rate without having to pay the $2,000 upfront.
But do your homework and work the numbers before you commit yourself to a particular loan or a specific lender.
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.