by Bob Rywick

Points paid in connection with the purchase or improvement of a principal residence are deductible in the tax year paid if payment of points is an accepted business practice in the area where the debt is incurred. However, the amount paid for points must not be more than the amount generally charged in that area.

Observation: A taxpayer often has a choice of whether to pay points when getting a mortgage or paying a higher interest rate on the mortgage without paying points. Whether the amount paid for points is not more than the amount generally charged in the area will depend, at least in part, on the reduction that the taxpayer gets in the interest rate.

What qualifies as a reasonable reduction will depend on the length of the mortgage. The shorter the mortgage, the greater the reduction in the interest rate should be in order to justify taking a mortgage with points. Of course, the more points that are paid, the greater the reduction in interest rates also should be.

Observation: In deciding whether to pay points to get a lower interest rate, the taxpayer should consider the present value of the total interest cost (including points) less the tax savings on the interest. Also, if a taxpayer expects to be in a higher tax bracket in the future, she may prefer to take a higher interest rate over the life of the mortgage than pay points now when she is taxed at a lower rate.

Another key factor to consider is how long the taxpayer expects to be in her home. Since mortgage points are nonrefundable, a taxpayer who sells her home within a comparatively short period of time after the purchase (e.g., five years) will have paid the mortgage points up front, but will have received a lower interest rate for only the period that she owned the house.

Example 1: Your clients, a married couple in their late 20s, are planning to buy a home for $300,000, and will need to take out a $200,000 mortgage to pay the purchase price. They expect to stay in this home at least until they retire, which they hope to do when they are in their early 60s. They have the choice of getting a no-points fixed-rate mortgage at a rate of 6 percent for 30 years, or a two-points fixed-rate mortgage for the same period at a rate of 5.75 percent.

If they get the 6 percent mortgage, they will pay total interest of about $231,677 over the life of the mortgage. If they get a 5.75 percent mortgage they will pay interest of about $220,174 over the life of the mortgage, plus points of $4,000 (2 percent of $200,000).

Thus, they will pay total interest (including points) of $224,174 if they take the 5.75 percent mortgage with two points, or over $7,500 less than their total interest cost if they take the 6 percent mortgage.

Even taking into account the fact that the present value of the $4,000 paid up front is more than the present value of the interest that they have to pay in the future, they will still probably be better off taking the 5.75 percent mortgage with points. This is especially so since more interest is paid in the early years of the mortgage than in the later years.

For example, of the total of $220,174 that will be paid over the life of the 5.75 percent mortgage, about $106,298 is paid over the first 10 years of the mortgage, and only about $33,733 is paid over the last 10 years.

Example 2: The same facts apply as in Example 1, except that your clients are looking at the home they are planning to purchase as a “starter” home. They hope to be able to sell it and buy a better home in about five years. If they sell the home five years after they purchase it, they will pay total interest of about $58,055 if they get the 6 percent mortgage without points, and interest of about $59,553 (including points of $4,000) if they get the 5.75 percent mortgage with two points. Thus, they will pay almost $1,500 more in total interest costs over five years if they get the 5.75 percent mortgage with two points than they would pay if they get the 6 percent mortgage without points. In this case, they will almost certainly be better off if they get the mortgage without points.

When points are not deductible in the year paid. Points paid to refinance a home mortgage are not deductible currently except to the extent that the proceeds are used to improve the home, and only if the borrower pays the charge out of his funds at the closing.

Thus, the points would not be deductible if payment were withheld from the mortgage loan. If part of the proceeds of a new mortgage are used to pay off the old mortgage, and part are used to improve the home, then the amount that is deductible currently is based on the ratio of borrowed funds used for improvements to the total amount of the loan.

If points aren’t currently deductible, they generally must be deducted over the life of the loan using OID-type economic accrual principles. However, if a mortgage loan is not more than $250,000, and is not for a period of more than 30 years, the Internal Revenue Service says that each year a borrower can deduct a pro rata part of the points not deductible in the year paid.

The amount deductible is determined by dividing the amount of the non-currently-deductible points charge by the number of monthly payments to be made on the loan, and multiplying the result by the number of mortgage payments made during the tax year. This pro rata method is not available if there are more than six points (more than four points if the period of the loan is 15 years or less).

Example 3: Your clients plan to get a loan of $200,000 secured by a 30-year mortgage on their home. Of the loan proceeds, $150,000 will be used to pay off the present mortgage on their home, and $50,000 will be used to pay for the addition of a new bedroom and bathroom. They have a choice of getting a 6 percent mortgage without points, or a 5.75 percent mortgage with the payment of two points ($4,000). If they pay the points to get the mortgage with a lower interest rate, only $1,000 (25 percent of $4,000) of the total amount paid for the points will be currently deductible.

Your clients will be able to deduct the $3,000 balance ratably over the 30-year term of the mortgage, or $100 (one-thirtieth of $3,000) each full year that the mortgage is outstanding.

When points should not be deducted in year paid even if taxpayer is eligible to do so. A taxpayer is not required to deduct mortgage points in the year paid even if she is eligible to do so. Instead, she may deduct them ratably over the life of the mortgage.

In some situations, a taxpayer may be may be better off deducting them over the life of the mortgage. This would be especially so if the taxpayer’s standard deduction was equal to, or almost equal to, the total of the taxpayer’s itemized deductions (including the points) in the year the points are taken. Also, if the taxpayer’s taxable income after deducting personal exemptions and itemized deductions other than the points is zero or substantially less than the points, then the taxpayer will probably be better off deducting the points ratably over the life of the loan.

Example 4: Your clients, a married couple who file a joint return, bought a house on Dec. 1, 2003, for $250,000. They had taxable income of $90,000 in 2003 after deducting personal exemptions, but before deducting either a standard deduction or itemized deductions.

In connection with the purchase, they obtained a 15-year mortgage at a rate of 5.25 percent, but had to pay two points ($4,000) to get the mortgage, even though they would have been willing to pay a slightly higher interest rate to get a mortgage with no points. They expect their itemized deductions for the year, including one month’s interest ($875) on the mortgage, but before taking the points into account, to be about $6,500. If you include a $4,000 deduction for points, their total itemized deductions will be about $10,500 or only $1,000 more than the standard deduction ($9,500) they can otherwise take on their 2003 return.

Thus, if they elect to itemize, they will get only a $1,000 benefit from the $4,000 in points that they pay. The remaining $3,000 will be lost. On the other hand, if they take the standard deduction they will be able to deduct the points ratably over the next 30 years at a rate of $133 a year (one-thirtieth of $4,000). However, in the last year they will be able to deduct only $122 (eleven-twelfths of $133). In effect, assuming that they itemize in later years, they will lose only $11 of the $4,000 they paid in points, i.e., the part of the points allocable to December of 2003.

Example 5: The same facts apply as in Example 4, except that your clients took the mortgage out on Feb. 1, 2003. Accordingly, they paid mortgage interest for 11 months in 2003 instead of just one month, or a total of $9,446. As a result, their total itemized deductions before taking the points into account was over $15,000. Thus, if they deduct the $4,000 paid for points, they will increase their itemized deductions to over $19,000. No part of the points will be lost.

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