Let’s say you bought a new home at a rock-bottom price or you refinanced a mortgage on your current home. In either event, you may have to pay the lender “points” for the privilege of obtaining a lower mortgage interest rate.
Each point is equal to one percent of the amount you’re borrowing. For instance, if you’re charged two points on a $150,000 loan, it will cost you $3,000. That might be a good trade-off for an interest rate that can save you tens of thousands of dollars over time.
Can you deduct the points as mortgage interest on your personal tax return? The answer generally is “yes.” But whether you’re entitled to a full deduction this year or only a partial deduction depends on your circumstances.
To claim a full deduction for the points paid on a conventional mortgage, you must meet the following requirements:
- The loan must be secured by your principal residence.
- Paying points is an established business practice in the area where you live.
- The points are generally equal to what is charged in your region.
- You use the cash method of accounting (i.e., you report income in the year received and deduct expenses in the year paid).
- The points are not paid as a substitute for amounts ordinarily stated separately on the settlement sheet (such as appraisal fees, inspection fees, title fees, attorney fees or property taxes).
- The amount of your down payment (plus any seller-paid points) must be at least as much as the amount of points charged.
- The loan is used to buy or build your principal residence.
- The points are computed as a percentage of the mortgage principal.
- The amount of the points is stated on the settlement sheet as points paid by the buyer or the seller. In other words, you can deduct the points even if the seller paid them!
Be mindful that the home must be your principal residence. You can’t immediately deduct points for a mortgage on a vacation home or second home.
The tax rules are a little trickier if you refinance an existing mortgage on your principal residence or take out a mortgage to buy a second home. Generally, you’re required to amortize the points over the life of the loan. For example, let’s say you obtain a favorable rate for a new 10-year mortgage in lieu of the 30-year albatross you’ve been carrying. The loan principal is $200,000 and you have to pay one point, or $2,000. In this case, you deduct $200 each year for a period of ten years.
On the other hand, if you’re taking out a loan or home equity line of credit to improve your principal residence, the points attributable to the home improvement are generally deductible in full in the year you paid them. The remaining balance of the points, if any, is amortized over the life of the loan.
In one court case, a couple was able to write off the full cost of the points even though the improvements took several years to complete (see right-hand box).
Suppose you’re refinancing your home for the second or third time. You don’t lose the tax benefit of the points that have not been deducted. You can currently deduct the portion of the points remaining from your prior loan.
Taxpayers Make Their Point
A couple residing in California paid $4,400 in points on a refinanced loan. They used the monthly savings from reduced mortgage payments to finance the cost of substantial home improvements, but the work wasn’t finished until four years later. However, the couple deducted the full amount of points on their tax return for the year the work began.
The IRS disallowed the $4,400 deducted for points and allowed an amortization of the amount based on the life of the mortgage.
When the IRS challenged the full deduction, the couple took the case to the Tax Court.
Taxpayer victory: The Court sided with the couple. It agreed that the points were paid “in connection with” home improvements as required under law. The judge in this case noted there is no specific requirement that the home improvements had to be completed in the year of refinancing. (Hurley, TC Summary Op. 2005-125)