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Tom Talks Taxes - April 22, 2023
When does a taxpayer deduct mortgage points?
Mortgage rates have increased significantly over the last year, so more taxpayers may pay mortgage points when they buy real property. It is important to know the proper tax treatment of mortgage points and potential tax planning opportunities to maximize the tax savings from the payment of mortgage points.
Mortgage points, also known as discount points or simply points, are fees a buyer pays directly to a lender in exchange for a reduced interest rate on a mortgage. Since points are prepaid interest, they are generally deductible to the buyer as long as the interest paid on the underlying loan is tax deductible.
§461(g) provides for two ways that a taxpayer using the cash method of accounting can deduct points paid for a loan:
Ratably over the life of the loan (default method), or
In the year paid (exception).
If a taxpayer does not qualify to deduct the points in the year paid or ratably over the life of the loan, or chooses not to use either of these methods, the points reduce the issue price of the loan, resulting in original issue discount.
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Ratable Deduction. Rev. Proc. 87-15 allows an individual taxpayer using the cash method to allocate points ratably over the life of a loan if they meet the following four requirements:
A residence secures the loan,
The loan term is no greater than 30 years,
The loan provisions are the same as other loans offered in the area for the same or longer period if the loan term is more than ten years, and
The loan amount is $250,000 or less, or the number of points does not exceed four (if the loan period is 15 years or less) or six (if the loan period is more than 15 years).
Rev. Proc. 87-15 also provides the method to calculate the annual deduction amount. The taxpayer first divides the total points paid by the total number of payments over the life of the loan and then multiplies that result by the number of payments due during the tax year.
Points paid for refinancing a loan, even for a primary residence, are generally allocated ratably over the life of the mortgage; however, in Rev. Rul. 87-22, the IRS ruled that a taxpayer may immediately deduct points properly allocable to primary residence improvements when a portion of loan refinance proceeds were used to make those improvements.
If a taxpayer deducts points ratably over the life of the loan and pays off the loan, the taxpayer can deduct the remaining points in that tax year. Refinancing a loan is trickier: if the taxpayer refinances the loan with a new lender, they can deduct the remaining points. However, if the taxpayer refinances with the same lender, they must deduct the remaining points ratably over the life of the new loan. See IRS Publication 936, Home Mortgage Interest Deduction.
Lump-Sum Deduction. Alternatively, Rev. Proc. 94-27 provides a safe harbor that an individual taxpayer using the cash method may use to deduct points in the year they are paid. The five requirements for the safe harbor are:
The amounts must be clearly designated as points (or loan discount or discount points) on the settlement statement,
The amounts must be calculated as a percentage of the principal loan amount,
In the area in which the taxpayer is buying the home, the amounts paid must conform to the established business practice of charging points for home mortgages and not exceed the amounts generally charged in that area,
The amounts are paid in connection with the acquisition of the taxpayer’s principal residence, and that residence must secure the loan, and
The amounts must be paid directly by the taxpayer.
Non-Deductible. If points are paid for the purchase of a residence, and the amount of the loan exceeds the limitation on the amount that qualifies as acquisition indebtedness, the points on the excess loan amount are not deductible.
In addition, points paid by a home seller are not deducted as interest on the seller's return; however, they are a selling expense that will reduce the amount realized in the sale. In Rev. Proc. 94-27, the IRS states that the buyer may deduct those points, but only if the buyer subtracts those amounts from the residence’s basis.
Taxpayer’s Choice. The IRS ruled in Private Letter Ruling 199905033 that a taxpayer who qualifies to deduct points in the year paid may choose instead to allocate the points ratably over the life of the loan.
In most cases, it is more beneficial to claim the deduction in the earliest year possible; however, if the taxpayer gets little-to-no value in the year the points are paid, then deferring the deduction may make sense.
Here are two situations in which a taxpayer should consider choosing to allocate the points ratably over the life of the loan:
The taxpayer will claim the standard deduction, even after including the points deduction on Schedule A.
The taxpayer gets little tax benefit in the year the points are paid and may get a more significant tax benefit in future years. This can occur because the taxpayer has a low marginal tax rate in the year the points are paid, or the amount allows them to itemize deductions, but only barely above the standard deduction amount.
Here is an example: Kyle and Oliver, who are married, bought a primary residence in November 2022 and paid $4,500 in points. Their first 30-year mortgage payment is due January 1, 2023, so the points are the only mortgage interest they paid in tax year 2022. As such, their standard deduction is higher, and they get no tax year 2022 tax benefit from deducting the points.
If they choose to allocate the points ratably over the life of the mortgage, they get an additional $150 mortgage interest deduction per year ($4,500 divided by 360 payments multiplied by 12 payments per year). This may or may not get them tax savings each year; it depends on whether they itemize deductions. However, another benefit to allocating the points ratably is that they can fully deduct them in a future tax year if they refinance with a different lender or pay off the existing mortgage.
While the future value of the deduction is unknown in this example, it is known for sure that there is zero tax benefit from deducting the points during tax year 2022. By choosing to allocate the points ratably over the life of the mortgage, Kyle and Oliver preserve a potential deduction for future use.
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