01/11/09: Deductions For Mortgage Interest and Points

Housing Counsel

By Benny L. Kass

(Second in a Series)

In the good old days, there was only one mortgage available – a fixed, 30-year loan.

Nowadays, however, there are many loans; in fact, there are so many mortgage loans on the market that consumers are confused and unfortunately are sometimes misled into obtaining a loan that is not in their best interest.

Everyone wants to get the lowest mortgage interest rate possible. Careful consumers will shop around, contact different mortgage lenders and try to negotiate for the best terms.

But do you really do the numbers? Do you look at the actual monthly payment which each loan will require?

For example, what do you think is better for a $250,000 loan: a 6 percent interest rate with one point or a 6 1/8 rate with no points? Keep in mind that a point is one percent of the amount loan – or in our example $2,500.

The monthly payment to amortize a $250,000 loan over 30 years at 6 percent will cost you $1498.88. This is only for principal and interest; we are not including taxes and insurance in this example. The monthly payment for that same loan at 6 1/8 percent will be $1519.04 – or $20.16 more a month.

But in order to get that lower rate, you will have to pay the lender one point in the amount of $2,500. It will take you 124 months (over 10 years) in order to break even and benefit 2 from that lower rate. ($2500 20.16 = 124 months).

In this example, I am not taking into consideration the tax deductible consequences of the higher interest rate as compared to the ability to deduct the point. Although these factors must also be considered as you ponder on what loan to obtain.

How long do you plan to stay in your new home? Do you have better use for the $2,500? Keep in mind that points – while possibly deductible for tax purposes – represent real money which you have to take out of your own pocket. The payment is usually up-front, in cash, since it generally is not included in the loan amount.

These are the kind of questions which potential homebuyers should consider when shopping for a mortgage.

The tax considerations should also be carefully reviewed. The interest you pay on a mortgage is generally deductible when you file your annual 1040 income tax return.

Let’s look at two aspects of this deduction:

Points: Lenders have different terms for points, such as loan discounts or origination fees. But regardless of their name, they represent money which you — the consumer — must pay.

Lenders can charge as many points as they can get away with, but at some level, the loan becomes usurious, potentially illegal, and may represent what is commonly known as “loan sharking”.

Lenders take risks. They lend money to a stranger, who may or may not be able to re-pay the loan in full. To secure repayment of the loan, the lender requires the borrower to sign a deed of trust (the mortgage document) whereby the house is put up as collateral (security) to guarantee full payment of the loan. Those of us who can remember back to the early l990’s, know that 3 houses can (and have) decreased in value, which makes the lender’s security potentially more risky.

The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge. But consumers should not take the lender’s statements about credit status on blind faith. It is often possible to get a better interest rate — or less points — from another lending source.

Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. It used to be that the IRS required the borrower to write a separate check to the lender for these points; in recent years, the IRS seems to have backed off of this position. However, it still makes sense to either write a separate check at closing — or at least have the settlement statement (the HUD-1) clearly reflect the number and amount of points you are paying.

If you pay points to obtain a refinance loan, however, in most circumstances those points can not be deducted in full for the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your mortgage loan. For example, you refinance and obtain a loan in the amount of $250,000. To get this new loan, you are required to pay two points — or $5,000. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year — or $166.67. However, if you pay off this loan early — say in five years either by selling your house or refinancing again — the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.

Talk to your potential lenders about trading interest rates for points. Generally speaking, each point that you pay is the equivalent of 1/8 of an interest rate. Thus, you may be able to get a loan at 6 1/8 percent with no points, but a 6 percent rate by paying one point.

Seller-paid points:
Often, a potential buyer presents a sales contract to a seller, and asks the seller to make some payment in order to seal the deal. Such concessions can include (1) the seller paying some or all of the buyer’s closing costs, (2) the seller giving a cash credit at settlement, or (3) the seller paying some or all of the buyer’s points.

For many years, the Internal Revenue Service disallowed seller-paid points from being deducted by the purchaser. In a complete about-face, however, back in l994, the IRS ruled that these points can be deducted by the purchaser. The Service announced that purchasers could generally deduct points required by mortgage lenders, even if those points were paid by the seller. This is generally referred to as “seller-paid points.”

Let us look at your example. You will pay $300,000 for your new house and obtain a loan of $250,000. The lender can give you lower interest if you pay 2 points – or $5000. If you can convince your seller to pay this — and have your sales contract reflect that the seller is paying this money as points –you should be able to fully deduct this $5,000 from your income tax which you file for the year of the purchase.

Taxpayers are reminded that the settlement sheet is perhaps the most important document received at settlement, and should be kept forever. This will be your best proof if you are ever challenged by the IRS.

There is one drawback. The amount of the points paid by the seller will be used to reduce the purchaser’s basis if the purchaser now deducts those seller-paid points. In our example, if the purchaser paid $300,000 for the property, and now deducts the $5,000 of seller-paid points, the cost basis to the purchaser is reduced by the amount of the points deducted.

Here, however, the current tax law (which will be discussed next in this series) may come into play. Under the Taxpayer Relief Act of l997, taxpayers can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence. This exclusion can be taken once every two years; the once-in-a-lifetime exclusion has been eliminated from the law.

Thus, under the new law, the taxpayer’s tax basis of his/her principal residence is relatively unimportant — unless the taxpayer makes a profit that exceeds the statutory dollar amounts.

Mortgage Interest: Lenders who receive interest payments of $600 or more in any one calendar year must file an information return with the IRS stating the amount of interest received. A copy of this return (called Form 1098) must also be sent to the person who paid the interest. During the month of January, every homeowner with a mortgage will receive this form, which will assist taxpayers in taking the appropriate mortgage interest tax deduction. Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married, but file separately, the limits are split in half.

In order to be eligible for the tax deduction, the debt must be secured. This means that there must be a deed of trust which is recorded among land records against your house. If the loan is not secured, you cannot deduct the interest which you pay.

I often run across this situation: parents want to help their children purchase a house, and lend them the down payment. The children are required to repay the loan over a period of years, with interest. If the parents will secure the loan (i.e. record the legal document) the children can 6 deduct the mortgage interest. Otherwise, the payments are considered as personal interest, which cannot be claimed as a deduction under current law.

(Next: Profit Exclusions when selling real estate)