Taxation Law (TA)

Even in the current low-interest environment, it seems points are still a common part of mortgage financing. Proper tax advice is essential before closing time regarding the deductibility of points paid on a mortgage loan. I've had to deal with this issue a couple of times recently (and have had a discussion with a couple of real estate attorneys on these rules over the past week) and thought this may prove helpful.

“Points” (certain charges to obtain a home mortgage loan, which are sometimes called “loan origination charges” or “loan discounts”) may be deductible^[1] if the loan is secured by the a principal residence, if the charging of points is customary in the area in the U.S. in which the expatriate lives and the points charged is in conformance with the amount generally charged in that area.^[2]  The points must also be paid from funds separate from the loan proceeds in order to be deductible.^[3] Points withheld by a lender from the proceeds of a loan are not deductible by the borrower in the year the amount was withheld because this withholding does not constitute “payment” within that year.[4] The deductibility is treated under the OID rules instead.[5] (More on this point later).

Points paid by the seller are generally not deductible by the buyer,^[6] but the buyer may deduct seller-paid points if the basis (purchase price) of the home is reduced by that amount.^[7]  Points paid on other types of loans may be deductible, but the points are treated as prepaid interest which must be deducted ratably over the life of the loan rather than deducted in the year paid.^[8]  

Because the IRS takes the position that points paid for refinancing are paid to repay existing debt and not in connection with the purchase or improvement of a residence, points incurred for refinancing arrangements are generally not deductible.^[9]

While the Tax Court adhered to the IRS stance on refinancing points^[10] the Eighth Circuit reversed, holding that a refinancing was, in fact, incurred in connection with a residence purchase because the taxpayer intended all along to refinance the original mortgage with more permanent financing.^[11] Since the IRS did not acquiesce in the Eighth Court’s decision[12] and outside the Eighth Circuit, it will generally continue to challenge current deduction of points incurred to refinance.

In addition, the Tax Court has held that points were not deductible by a taxpayer who paid points to replace a variable rate mortgage with a fixed rate mortgage.[13]  The Tax Court held the points were not deductible because the later mortgage was incurred simply to obtain better financing terms, not to acquire the principal residence.  The Tax Court distinguished this case from the Eighth Circuit’s holding by noting that under the Eighth Circuit’s analysis, merely paying off a short-term loan through refinancing can be considered as an integral step toward finalizing the acquisition of a residence.

Under Rev. Proc. 94-27, the IRS has created an administrative safe harbor for the deductibility of points in the year paid by a cash-method payer if the following five requirements are met.

• The points are paid in connection with the acquisition of the taxpayer’s principal residence, which must be used to secure the loan
• The amount must be clearly designated as “points” (or “loan discount” or “discount points”) on the Form HUD-1 settlement statement
• The points must be calculated as a percentage of the principal loan amount
• In the area in which the taxpayer is buying the home, the points amount must conform to the established business practice of charging such points for home mortgages and not exceed the generally-charged amount in that area
• The points must be paid directly by the taxpayer

With respect to the fifth point above, points are considered to have been paid directly by the buyer if the points amount was paid from a down payment, escrow deposit or earnest money or other funds applied at the closing.  Points paid by the seller may also qualify (but this gives rise to a reduction in buyer basis, not a points deduction).  The IRS has privately indicated that points were deductible when the borrower provided a check at closing for points payment (but the lender had deducted the closing costs from the loan proceeds).[14]

This safe harbor specifically does not apply to points paid for:

• Home acquisition loans to the extent the principal amount exceeds the $1 million acquisition indebtedness limit
• For a home improvement loan
• A refinancing loan, home equity loan or line of credit secured by the home, or
• A loan to buy or improve a second home (including a vacation home, investment property or trade or business property).

Withholding points from loan proceeds serves to reduce the issue price of the loan and creates OID. While a cash-basis taxpayer can amortize the point ratably over the loan term, other taxpayers must deduct in accordance with OID rules. This exception for cash-basis taxpayers exists as an administrative convenience. IRS guidance on this issue is found in Rev. Proc. 87-15, 1987-1 CB 624.

For a recent study about points (a joint study between Freddie Mac and Penn State) which may prove helpful in advising clients on the subject of points, see http://www.hsh.com/pointofpoints.html