With the significant increase in mortgage rates over the past year, more taxpayers may find themselves paying mortgage points when they purchase homes. Understanding the proper tax treatment of mortgage points is crucial to maximize potential tax savings.
Mortgage points, also known as discount points or simply points, are fees paid by the buyer directly to the lender in exchange for a reduced interest rate on a mortgage. These points are considered prepaid interest and are usually deductible to the buyer, as long as the interest paid on the underlying loan is tax deductible.
§461(g) offers two ways for taxpayers using the cash method of accounting to deduct points paid for a loan:
- Ratable deduction over the life of the loan (default method).
- Deduction in the year paid (exception).
If a taxpayer is ineligible for either method or chooses not to use them, the points will reduce the issue price of the loan, resulting in original issue discount. It is important to explore all available options for deducting mortgage points to maximize tax savings.
Ratable Deduction (default). Rev. Proc. 87-15 allows taxpayers using the cash method to deduct mortgage points by allocating them evenly over the life of a loan if the following four requirements are met:
- The loan is secured by a residence
- The loan term is no longer than 30 years
- The loan provisions are similar to other loans in the area, if the loan term is more than ten years
- The loan amount is $250,000 or less, or the number of points does not exceed four (if the loan period is 15 years or less) or six (if the loan period is more than 15 years).
To calculate the annual deduction amount, divide the total points paid by the total number of payments over the life of the loan, and then multiply that result by the number of payments due during the tax year.
If the taxpayer pays off the loan after deducting points ratably over its life, they can deduct the remaining points in that final tax year. If the taxpayer refinances with the same lender, they must deduct the remaining points ratably over the life of the new loan. If they refinance with a new lender, they can deduct point immediately.
Lump-Sum Deduction. If the taxpayer wants to deduct all the points they paid in one year, they can use Rev. Proc. 94-27. It provides a safe harbor with five requirements:
- The amounts the taxpayer paid must be clearly labeled as points (or loan discount or discount points) on your settlement statement.
- The amounts the taxpayer must be a percentage of their loan principal.
- The amounts paid must follow the usual business practice in their area and not be higher than what's typically charged.
- The amounts must be paid in connection with buying the main home, which secures the loan.
- The money must be paid directly by the tax payer.
Please note: If you pay points for buying a home and the loan amount is more than what qualifies as acquisition indebtedness (750K), then the portion of points paid on the amount that exceeds the limit are not tax deductible
Taxpayers have a choice when it comes to deducting points. According to Private Letter Ruling 199905033 by the IRS, a taxpayer who is eligible to deduct points in the year they are paid can choose to spread out the deduction over the loan's life instead.
Usually, it's better to take the deduction in the year the points are paid. However, if the taxpayer doesn't get much tax benefit in the year of payment, it may make more sense to defer the deduction.