8039 / How are prepaid interest and points treated for tax purposes?

Cash basis taxpayers must generally allocate prepaid interest payments to the year or years in which payments represent a charge for the use of borrowed money and may take a deduction only for the amount properly allocable to the specific tax year. However, points paid on debt incurred to buy or improve (and secured by) the taxpayer’s principal residence are generally excepted from the prepaid interest limitation if payment of points is an established business practice in the area and the amount does not exceed the amount generally charged in the area.¹

The IRS has stated that points paid in connection with the acquisition of a principal residence will generally be deductible by a cash basis taxpayer in the year paid if all of the following requirements are satisfied: (1) the amount is clearly shown on the settlement statement as points charged for the mortgage; (2) the points are computed as a percentage of the principal amount of the debt; (3) the payment of points is an established business practice in the area, and the amount of points paid does not exceed the amount generally charged in that area; (4) the points are paid in connection with the acquisition of a principal residence, and the loan is secured by that residence; (5) the points do not exceed the sum of the funds provided at or before closing by the purchaser, plus any points paid by the seller, and such funds paid by the purchaser may not be borrowed from the lender or mortgage; and (6) the points may not be a substitute for amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, property taxes, etc.²

The fact that a full deduction was available for points in the year they were paid did not mean the taxpayers were required to claim it in that year, according to a private letter ruling. A couple for whom it was more advantageous to take the standard deduction in the year the mortgage was obtained was not precluded from amortizing the points over the life of the loan, starting in the following tax year.³

In the event that points are paid by the seller (or charged to the seller) in connection with a loan to the taxpayer, they can still be treated as paid directly by the taxpayer if all the tests above are met, and provided that the taxpayer subtracts the amount of any seller-paid points from the purchase price of the home in computing its basis. But such treatment is not available for the following: (a) the amount of points paid on acquisition and allocable to principal in excess of the amount that may be treated as acquisition indebtedness; (b) points paid for loans used to improve (as opposed to acquire) a principal residence; (c) points paid for loans used to purchase or improve a residence that is not the taxpayer’s principal residence; and (d) points paid on a refinancing loan, home equity loan, or line of credit.⁴ Loan origination fees include points paid on FHA and VA loans if the points were paid during taxable years beginning after 1990.⁵

Refinancing. Points paid on refinancing a principal residence must generally be amortized over the life of the loan.⁶ However, a taxpayer who was able to establish a direct link between acquisition of a residence and the necessity of refinancing to complete that step was permitted to take a current deduction for such points.⁷

In Hurley v. Comm.,⁸ the Tax Court stated that IRC Section 461(g)(2) provides two instances where a taxpayer may deduct the entire amount of points paid to refinance a personal residence: when the taxpayer (1) refinances in order to purchase a new home; or (2) refinances in order to make improvements to the home. Consequently, the court stated, points paid when a taxpayer refinances a personal residence simply or only for the purpose of obtaining a lower payment are not deductible (citing Kelly v. Comm.⁹). The court further stated that IRC Section 461(g)(2) applies if a taxpayer pays points to refinance in connection with the improvement of his principal residence; and based on the intent of Congress, the Tax Court applies a broad interpretation of the phrase “in connection with.” In Hurley, the Tax Court upheld the taxpayers’ $4,400 deduction for points they paid to refinance their mortgage where the evidence (testimonial and otherwise) demonstrated to the court’s satisfaction that the taxpayers had negotiated the refinancing of their personal residence in order to finance their home improvements (e.g., the home improvements started nine days after the refinancing). The court acknowledged that the taxpayers had saved money as a result of the refinancing, but also noted that the refinancing had financially enabled the taxpayers to complete the improvements to their principal residence. The court determined it was immaterial that the cost of the taxpayers’ improvements ($18,735) exceeded their savings from the refinancing ($14,400) because the difference was not grossly disproportionate.

If part of the refinancing proceeds are used to improve the taxpayer’s principal residence, the portion of points allocable to the improvements may be deducted in the year paid.¹⁰

The IRS has stated that if a homeowner is refinancing a mortgage for a second time, a taxpayer may deduct all the not-yet-deducted points from the first refinancing when that loan is paid off.¹¹