With interest rates nearly scraping the bottom of the barrel, it's a great time to buy a new home or refinance your mortgage (and save big bucks on interest payments). Every loan comes with "points" -- also known as "loan origination fees," "maximum loan charges," "loan discount," or "discount points" -- which simply represent the interest you pay up front on the loan. But how should you deal with that interest come tax time?
Since they represent an interest expense, points are tax-deductible. The challenge lies in how you decide to treat them. With an immediate deduction, you can report the full amount of up-front interest in the year of payment. But an amortized deduction must be spread out over the life of the loan.
Let's quickly illustrate the difference. Suppose Pam incurs $1,800 in points on July 1, 2005 -- the closing date of her 30-year loan. Pam determines that she must amortize her points, so she divides the amount of points ($1,800) by the length of the loan (30 years.) She calculates that her amortized deduction will be $60 for each year of the loan.
Remember, that number covers an entire year's deduction -- but Pam's loan closed July 1, midway through the tax year. To figure out how much she'll be able to deduct for this first year, Pam has to divide that $60 annual deduction by 12 months, then multiply it by the six months her loan was in force. For her first year's taxes, she can only deduct $30 in loan points.
How can you tell when points can be fully deducted, and when they must be amortized? For an immediate and full deduction, you must meet all of the following requirements:
- The settlement or loan statement must clearly identify the amount of the points, whatever they're called. (Note that lengthy list of aliases at the beginning of this story.)
- The points must be computed as a percentage of the principal amount of the loan.
- The amount paid as points must not exceed the normal rates charged in your area. Any additional amount paid must be amortized. This would include "buying down" the interest rate on your loan by paying additional points. In that case, only the normal points are immediately deductible; you'll have to spread out the rest over the life of the loan.
- The points must be paid on a loan to purchase or build your principal residence. The loan must also be secured by that residence. If you pay points for a loan to buy a second home, you'll have to amortize them.
- The points must be paid directly with your own funds -- they can't be financed. Understand that down payments, escrow deposits, earnest money, and any other funds paid at the closing will count as payment of points as long as these amounts equal or exceed the points charged. If the points are paid from the loan proceeds, they must be amortized.
- You must use the cash method of accounting. (Luckily for you, nearly everyone does.)
Note that the designated "loan origination fees" on Veterans Administration and Federal Housing Administration loans also qualify as deductible points if the requirements above are met.
Let's look at the deductibility of some specific types of points. Remember that in each of these cases, all of the six requirements we just discussed must also be met:
Home improvement loan points: As long as the loan applies to your principal residence, these points are fully deductible in the year paid. Home-improvement loans for other residences don't qualify; you'll have to amortize them.
Seller-paid points: Homebuyers are allowed to list seller-paid points as an itemized deduction on Schedule A. In the IRS' view, the seller has paid that sum to the buyer, who has then turned around and paid the same amount to the lender. Of course, there are restrictions to this general rule. Aside from the Big Six we examined earlier, the closing statement must clearly indicate a credit given for seller-paid points.
Refinance points: If you refinance a loan to get a lower interest rate (or for any other reason), you'll probably get hit with points. Whether you pay these points or finance them, you must amortize them.
But what if you borrow additional funds at the same time you're refinancing, and use some of that extra money to substantially improve your primary residence? In that case, you may be able to fully deduct some of those loan points.
Suppose that Emily and Joe have a mortgage loan balance of $42,000. They decide to refinance the original loan, borrowing $60,000 -- the original loan amount plus an additional $18,000 to put a second story on their principal residence. They pay $2,000 in points for the refinanced loan.
Assuming that they didn't finance those points, they will be allowed to fully deduct 30% of the total points, or $600, in the year that the points were paid. To arrive at 30%, they divide the amount of the new home-improvement funds ($18,000) by the total amount of the new loan ($60,000). Emily and Joe will still have to amortize the remaining $1,400 in points over the life of the loan.
Home equity line of credit points: In most cases, points paid for an "equity line" of credit -- one secured by the home itself -- must be deducted over the effective duration of the credit line. However, if the funds from a line of credit are used for improvements on your primary home, they can be fully deducted in the same year they're paid.
Deducting the unamortized balance of points: What if you've amortized your points, but have now fully paid back your loan ahead of schedule? Don't despair -- the unamortized balance of the points can be immediately deducted if and when the loan is completely repaid.
Remember Pam and her $60 annual amortized deduction? Suppose that after making that initial $30 deduction in 2005, and subsequent $60 deductions in 2006 and 2007, she refinances her loan on Jan. 5, 2008. She's already deducted $150 of the $1,800 in points from her original loan, leaving her with an unamortized balance of $1,650. Since her old loan has been paid in full, Pam can deduct that remaining balance in full on her 2008 tax return. (This is, of course, in addition to any points from the new loan, which she may be required to amortize.)
Points can get complicated, but the underlying math is fairly simple. You've just got to know the rules and apply them correctly. No matter how you take it, deducting points will help reduce your taxes. The next time tax season rolls around, make sure you don't miss the point.
When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns, as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.