Deductibility of mortgage points and interest.

While rising interest rates have slowed the demand for mortgage financing, clients who purchased homes or refinanced existing mortages while interest rates were at their lowest levels in 25 years now must confront the tax consequences of their actions. Some clients still seek mortgages to buy or refinance homes, while others want to replace variable with fixed rate loans or tap accumulated home equity. All of these clients need to know if and when mortgage points and mortgage interest are deductible. To help CPAs explain the proper income tax treatment of points and interest, this article explains the often complex deductibility rules.

DEDUCTIBILITY OF MORTGAGE POINTS

Taxpayers usually pay points--also referred to as loan origination fees, loan processing fees, maximum loan charges or premium charges--when closing a mortgage to secure a lower interest rate over the life of the loan. Internal Revenue Code section 461(g)(2) considers points prepaid interest and says they are deductible as interest if paid directly by taxpayers out of their own funds to a bank or financial institution for the use of money and not for specific services performed in connection with a loan.

Paid directly and out of their own funds are significant in determining the tax treatment of points. If taxpayers provide at closing amounts equal to the points through down payments, escrow deposits, earnest money or other personal funds, the points are deductible interest. But what if the lender withholds the points by subtracting them from the loan?

In Rubinitz, the Tax Court held that when a borrower receives loan proceeds of less than the amount he or she must repay, the difference does not constitute a payment of interest. The court also said if taxpayers receive the full amount they must repay, then separately pay the points, that payment is not an interest payment. In Schubel, the Tax Court further held withholding points from mortgage loan proceeds does not constitute payment in the year of withholding.

Withholding reduces a loan's issue price, creating an original issue discount (OID). Under IRC section 163(e)'s OID rules, deductions are based on the daily portion of the OID, which is determined by allocating part of the increase in the loan's adjusted issue price to each day of the year in question. The sum of each day's allocated amount is the portion of OID allowed as an interest deduction for the taxable year.

Seller paid points. Until recently, points paid by a property seller generally were not deductible as interest because they were not considered paid directly by the taxpayer. In revenue procedure 94-27, however, the Internal Revenue Service said seller-paid points would be treated as paid directly by the taxpayer from funds not borrowed for this purpose, provided the taxpayer reduces the basis of the new residence by an amount equal to the sellerpaid points. This new procedure is effective for points paid by cash basis taxpayers during tax years beginning after December 31, 1990. Taxpayers who otherwise meet the requirements for deducting points as interest may file amended returns for 1991, 1992 and 1993 to elect the new procedure.

Deduction timing. Points, like other interest payments, generally are deductible ratably over a loan's life. However, cash basis taxpayers may deduct points in the year paid if the following section 461(g)(2) requirements are met:

1. Paying points is an established local lending practice.

2. The underlying loan is used to purchase or improve a principal residence and is secured by the residence.

3. The amount paid does not exceed the amount of points generally charged in the area.

In revenue procedure 94-27, the IRS said it would consider points deductible in the year paid if the above requirements and these additional ones were met:

1. The Uniform Settlement, prescribed under the Real Estate Settlement Procedures Act of 1974, clearly designates the amounts in question as points incurred in connection with the indebtedness by labeling them loan origination fees, loan discount, discount points or points.

2. The amounts are stated as a percentage of the loan principal.

3. They are paid directly by the taxpayer.

Exclusions from revenue procedure 94-27. Home improvement loans are specifically excluded from the scope of revenue procedure 94-27. Cash basis taxpayers still may deduct points on home improvement loans under section 461(a)(2) if they carefully substantiate that the points represent interest prepaid with funds that are not loan proceeds.

Revenue procedure 94-27 also does not apply to points paid on refinancing loans, home equity loans or lines of credit, even if such indebtedness is secured by a principal residence. The IRS says a new mortgage loan used solely to repay existing indebtedness does not qualify under the section 461(g)(2) exception because the proceeds are not used to purchase or improve the taxpayer's principal residence. That the indebtedness secured by the new mortgage was incurred in connection with "continued ownership" of the taxpayer's principal residence does not change this position.

Eighth Circuit anomaly. Contrary to the IRS position, the Eighth Circuit Court of Appeals, in Huntsman, allowed homeowners to deduct points on a long-term mortgage replacing a short-term loan used to buy their home. The taxpayers in Huntsman obtained a 3-year balloon loan to buy a home, later replacing it with a 30-year loan. Saying refinancing loan proceeds generally are used to repay existing loans, lower interest costs or otherwise achieve a financial goal not directly associated with home ownership, the Tax Court ruled the points were not deductible in the year paid. In reversing the Tax Court, the Eighth Circuit ruled the refinancing debt was connected with the home purchase because the short-term financing was an integrated step in securing permanent financing.

The IRS says it will not follow Huntsman outside the Eighth Circuit, so only cash basis taxpayers living in Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota or South Dakota can deduct points on a refinancing loan comparable to the one in Huntsman without IRS opposition. Taxpayers living elsewhere may have to deduct the points on such loans ratably over the loan's life.

MIXED MOTIVE FOR LOAN

If a taxpayer refinances a mortgage both to obtain a lower interest rate and to improve his or her principal residence, only points related to improvements are deductible in the year paid. The remainder are deductible ratably over the loan's life.

For example, Bob and Barbara Brown obtained an 11% mortgage to buy a new residence in 1991. They refinanced the loan in 1994 with a 15-year mortgage at 7%. The Browns paid three points, $6,000, out of private funds to get the new loan. They used 50% of the proceeds to repay the remaining indebtedness on the house and the other 50% to improve it. Assuming all other requirements for deducting points are met, the Browns can deduct 50% of the points, $3,000, in 1994 as prepaid interest attributable to home improvements. They can deduct the remaining $3,000 ratably over the loan's 15-year life.

Revenue procedure 87-15 provides guidance on determining the proper annual deduction for points deductible ratably over the life of a loan secured by a residence. If the loan term is more than 10 years, all of the following conditions must be met before the prescribed method can be used to compute deductions:

1. The debt provisions must be customary in the geographic area for residential loans involving the same or a longer loan term.

2. The loan must not exceed $250,000.

3. The points charged must not exceed four if the loan term is less than 15 years and six if the loan term is 15 years or more.

Under the prescribed method, a borrower first divides the points by the number of payments due over the loan life and multiplies this amount by the number of payments made in the current year plus the number of payments due in the current year but paid in a previous year.

Refinancing more than once. Taxpayers who refinance personal residences more than once may deduct any remaining points from the first refinancing--those being deducted ratably over the loan life--in the year of any subsequent refinancing. Similarly, if a mortgage ends early due to prepayment or foreclosure, taxpayers can deduct the remaining points in the year it ends.

DEDUCTIBILITY OF MORTGAGE INTEREST

Interest paid on qualified residence debt enjoys special tax treatment. As long as liberal statutory requirements are met, the interest is fully deductible. By contrast, any other personal interest is completely nondeductible for tax years beginning after 1990. There are two types of qualified residence interest: qualified home acquisition debt and qualified home equity debt.

Qualified home acquisition debt. A mortgage obtained after October 13, 1987, to buy, build or substantially improve up to two qualified residences is qualified home acquisition debt; interest on such debt is fully deductible. A residence must contain sleeping space, a kitchen and a toilet, so a boat with living quarters or a mobile home both qualify. The first qualified residence must be the taxpayer's principal residence, as defined in IRC section 1034 (rollover of gain on the sale of a personal residence). The second often is a weekend or vacation home, which qualifies only if personal use exceeds the greater of 14 days or 10% of the time the unit is rented. If a vacation home is not rented, it qualifies as a second residence even without 14 days of personal use.

Buy and build have their usual meanings and thus are not difficult to prove. If proceeds are used to substantially improve a qualified residence, however, the meaning is not readily apparent. The IRS defines substantially improve to include any capital improvement that

* Adds to the home's value.

* Prolongs its useful life.

* Adapts the home to new uses.

Once taxpayers buy or build qualified residences, making substantial improvements is the only way to increase acquisition debt without buying another home. Generally, the mortgage must be secured by the qualified residence--that is, by a recorded mortgage or deed of trust on the property--to qualify for the interest deduction. Debt secured by a qualified residence and used to refinance the home acquistion debt also qualifies as home acquisition debt, but only to the extent of the old mortgage principal balance immediately before refinancing. Any excess is not home acquisition debt but may qualify as home equity debt (described below).

Special rules may allow deductions for all or some mortgage interest even though the mortgage is not secured by the taxpayer's residence. For example, interest is deductible if local homestead or debtor protection laws make the interest unenforceable or if the loan is secured by cooperative stock. In addition, some employers allow workers to borrow cash from their retirement plans. On loans secured only by a worker's plan balance, interest is not deductible as qualified residence interest but is deductible if the loan is secured by both the account balance and the home itself.

To qualify for an interest deduction, home acquisition debt cannot exceed the cost of the home plus any improvements; the total qualified residence debt cannot exceed $1 million ($500,000 if married and filing separately). Although most taxpayers are unaffected by this limit, those who are can deduct interest on an additional $100,000 of properly secured home equity debt.

Qualified home equity debt. Interest paid on home equity debt (for example, a second mortgage or home equity credit line) incurred after October 13, 1987, and secured by a qualified residence is deductible as long as the home equity debt does not exceed the lesser of $100,000 and the taxpayer's equity in the home (the home's fair market value less the acquisition debt). The disposition of the loan proceeds is irrelevant; thus, for example, the proceeds may be spent for a child's education, for travel or for a car. However, loan interest is not deductible if the deduction is barred under another tax law provision--for example, interest to purchase or carry tax-exempt securities.

Grandfathered debt. Home acquisition or home equity debt incurred on or before October 13, 1987, is treated as home acquisition debt, meaning neither the $1 million limit nor the $100,000 home equity loan limit applies. However, the $1 million limit on acquisition debt incurred after October 13, 1987, is reduced--but not below zero--by the grandfathered debt.

If debt incurred on or before October 13, 1987, is refinanced for less than the principal balance, the debt still is considered grandfathered and interest is deductible. Any amount refinanced in excess of the mortgage principal is home acquisition or home equity debt. The refinanced debt is grandfathered only for the old debt's remaining term. For example, if grandfathered debt has 8 years remaining when the taxpayer refinances with a new 15-year mortgage, the new loan is considered grandfathered debt for 8 years. Thereafter, the loan must qualify as home equity debt or home acquisition debt. Loans used to refinance balloon notes and other unamortized debts are grandfathered over the shorter of the old loan term or 30 years.

Grandfathered home equity credit lines may present special problems. Secured by the home, these loans allow owners to borrow varying amounts up to the loan limit. Since loan amounts may exceed the limit after October 13, 1987, only a portion may be grandfathered; the excess may qualify as home equity debt.

SPECIAL RULES

Special rules govern the deductibility of mortgage points and interest. Home buyers must understand these rules to gauge the economic impact of buying, improving, refinancing or borrowing against their homes. CPAs must have a working knowledge of the rules to help others understand the tax consequences. Knowledge of the deductibility rules presented in this article should enable practitioners and home owners to determine consistently if and when a deduction is allowed for mortgage points or interest.

EXECUTIVE SUMMARY

* EVEN THOUGH HOME MORTGAGE rates are rising again, clients still are seeking financing to buy or refinance homes, replace variable rate loans or access home equity. In most cases they will pay points, which may or may not be tax deductible. Interest deductibility depends on certain rules, including how loan proceeds are used.

* POINTS ARE DEDUCTIBLE AS interest if taxpayers pay them out of their own funds to a bank or financial institution for the use of money--usually to secure a lower interest rate. Points are not deductible if they are withheld from the loan proceeds or if the taxpayer pays them with borrowed funds.

* WHILE POINTS GENERALLY ARE deductible over a loan's life, cash basis taxpayers can deduct them in the year paid if paying them is an established local lending practice, the loan is used to purchase or improve a principal residence and the amount does not exceed that generally charged in the area.

* MORTGAGE INTEREST THAT qualifies as home acquisition debt--to buy, build or substantially improve up to two residences--is fully deductible in the year paid. A residence must include sleeping space, a kitchen and a toilet and thus would include boats with living quarters or mobile homes.

* FOR QUALIFIED HOME EQUITY debt, interest is deductible as long as the debt does not exceed the lesser of $100,000 and the taxpayer's equity in the home. There are no restrictions on how loan proceeds are used.