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Deductibility of home mortgage points.

DEDUCTIBILITY Of Home Mortgage Points

Points are paid by a borrower to a lender as a prepaid interest charge for the loan in the year the loan is made. This article discusses the general deductibility of points for home mortgage loans, with special attention on refinancing loans.

Deductibility of Home Mortgage Points

Points are not considered to merely relate to the year in which they are charged and paid. Rather, points are viewed as relating to the full term of the loan. This means that points are considered to be prepaid interest. Section 461(g)(1) requires that prepaid interest only be deducted when the interest accrues. Therefore, points must generally be amortized over the loan period.

However, Section 461(g)(2) provides an exception for home mortgage points, which may be fully deducted in the year paid by a cash basis taxpayer if four criteria are met. First, the points must be paid in respect of any indebtedness incurred in connection with the purchase or improvement of a principal residence. Second, the indebtedness must be secured by the principal residence. Third, the payment of points must be an established practice in the area in which the indebtedness is incurred. Fourth, the payment of points must not exceed the amount generally charged in the area.

Section 163(h)(4)(A) allows a mortgage interest deduction on a qualified residence. A qualified residence is a principal residence and one other residence. Under Section 461(g)(2), the immediate deductibility of home mortgage points is only applicable to a principal residence.(1) Therefore, points paid on a second qualified residence must be amortized over the life of the loan. However, these points will not be subject to the phase-out applicable to consumer interest. After 1990 consumer interest is no longer deductible.

To qualify as points, the charge must be compensation for the use or forebearance of money. Many times points will be referred to as a loan origination fee on escrow documents which detail items of the acquisition cost. However, classification of an item as points or loan origination fee will not automatically guarantee deductibility.

What constitutes compensation paid for the use or forebearance of money is controlled by the facts, not terminology.(2) A loan origination fee paid on a Veterans Administration guaranteed loan did not qualify as interest where one point was charged regardless of the money market. The fee charged the borrower was not in lieu of a higher interest rate.(3) Similarly, an initial service charge imposed for an FHA loan was for services, not the use or forebearance of money.(4) If a fee is for both services and the use of money, the service portion must be separated from the interest portion. The interest portion will still be considered interest provided it can be separately identified.(5)

For tax planning purposes, a borrower should obtain adequate documentation from the lender that items on an escrow document classified as points or loan origination fee are for the use of money. Service charges should be separately stated. This will help to avoid confusion as to the nature of the charges.

Method of Payment

An issue has arisen as to how home mortgage points must be paid in order to be fully deductible in the loan year. The controversy has stemmed from the language of Section 461(g)(2) that the points be "paid." It was argued by some taxpayers that withholding points from the loan proceeds would qualify as payment.

In Schubel, interest charged for points on a home loan was withheld by the lending institution from the loan proceeds. The Tax Court held that receipt of discounted loan proceeds did not constitute payment because "the payment required to entitle a cash basis taxpayer to a deduction is the payment of cash or its equivalent and the giving of a note is not the equivalent of cash."(6)

A home buyer who wants to ensure full deductibility of points in the year of acquisition could write a separate check drawn on a personal bank account for the amount. Even if the taxpayer must borrow money to pay points, the payment will be deductible if the borrower has unrestricted control over the borrowed funds. One method of establishing control over borrowed funds is for the taxpayer to deposit loan proceeds into a separate bank account where they are commingled with other funds.(7) However, a prearranged retransfer of loan funds back to the lender will not be considered payment giving rise to a deduction.(8)

Recently, however, the IRS appears to have abandoned its position in Schubel. Notice 90-70 deals with Section 6050H(b)(2)(C) which requires lending institutions to report points paid by a borrower on principal residence acquisition loans made after 1990. The notice states that "in view of standard commercial lending practices for purposes of this reporting requirement an amount charged to the mortgager as points with respect to the acquisition of a principal residence will be treated as paid directly by the mortgager." Thus withheld points will be immediately deductible. The notice only applies to acquisition indebtedness, not substantial improvements or refinance indebtedness (discussed below). Normally, points withheld from loan proceeds are deductible over the life of the loan.(9)

Refinance Points

The deductibility for home mortgage refinance points was codified by TRA, as amended by the Revenue Act of 1987. Section 163(h)(3)(A) allows an interest deduction on "any" acquisition and home equity indebtedness on a qualified residence (defined earlier). Acquisition indebtedness and home equity indebtedness are subject to $1 million and $100,000 caps respectively. Acquisition indebtedness is any indebtedness used to acquire, construct or substantially improve any qualified residence and which is secured by the residence.(10) Home equity indebtedness is any other indebtedness secured by the residence which does not exceed the fair market value of the residence reduced by acquisition indebtedness.(11) Thus, if a qualified residence costing $120,000 has been paid down to $100,000 and has a fair market value of $160,000, home equity indebtedness will be limited to $60,000 ($160,000 - $100,000). Acquisition indebtedness is the remaining $100,000 mortgage.

Section 163(h)(3)(B) includes in the term "acquisition indebtedness" refinancing indebtedness but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness. The committee report gives an example of acquisition indebtedness of $85,000 which has been paid down to $60,000. Refinanced acquisition indebtedness cannot exceed $60,000 unless the additional proceeds are used to substantially improve the residence.(12)

Since Section 163(h)(3)(A) allows an interest deduction on any qualified residence, the points paid on refinance acquisition and home equity indebtedness will be deductible subject to the $1 million and $100,000 caps. Thus, assume a taxpayer borrows $130,000 on a residence which costs $70,000, has been paid down to $50,000 and is worth $200,000. Points on the first $50,000 are deductible as refinance indebtedness while points on the remaining $80,000 are deductible as home equity indebtedness. The issue is when the points are deductible. Section 163(h) is a deduction statute while Section 461(g)(2) is a timing statute.(13) It is clear that points on the home equity indebtedness must be deducted over the period of the loan because Section 461(g)(2) only allows an immediate deduction for points paid in connection with the purchase or improvement of the principal residence.

But what about the points paid on the $50,000 refinanced acquisition indebtedness? This became an issue in 1986 when many taxpayers began to refinance home mortgage loans with lower interest rate loans. In March, 1987, the Service issued Rev. Rul. 87-22 which held that the proper treatment of points on these loans was amortization over the life of the loan.

The Tax Court considered the issue of immediate deductibility in Huntsman. In 1981 the taxpayers financed the purchase of a principal residence by obtaining a three-year loan with a balloon payment at the end of the loan period. In 1982 they acquired a home improvement loan. In 1983 they obtained a 30 year permanent loan which was used to pay off the prior two loans. The Court held that points paid on the permanent loan were not currently deductible because of the Section 461(g)(2) requirement that the loan be incurred in connection with the purchase or improvement of the principal residence. The Court cited language from the legislative history of Section 461(g)(2) that "a loan will not qualify under this exception if the loan proceeds are used for purposes other than purchasing or improving the taxpayer's principal residence."(14)

There was a dissenting opinion in Huntsman. The Eighth Circuit relied heavily on the dissent to reverse the decision. The appellate court rejected the Tax Court interpretation of Section 461(g)(2) that the section's language which mentions "in connection with" requires all indebtedness to be "directly related to the actual acquisition of the principal residence." The court noted that no such language could be found in the legislative history. Rather, the Eighth Circuit argued that the language of Section 461(g)(2) which allows immediate deductibility "in connection with the purchase" of a principal residence be broadly construed.(15)

The Eighth Circuit relied on the Supreme Court's decision in Snow for a broad interpretation of "in connection with." Snow involved a limited partner who took deductions for his share of losses for research and experimental expenditures. Section 174(a)(1) allows such a deduction for expenditures incurred "in connection with" the taxpayer's trade or business. The Supreme Court rejected the interpretation of "in connection with" a trade or business as requiring the taxpayer to actually carry on a trade or business, as provided in Section 162(a)(1), for ordinary and necessary expenses to be deductible. Rather, the Snow court held that the term "in connection with" was intended to "dilute some of the conception of `ordinary and necessary' business expenses under Section 162(a)."(16) The Huntsman court also cited a number of other instances where the term "in connection with" has been broadly construed.(17)

The Eighth Circuit examined the facts of Huntsman and found that obtaining the final loan to extinguish the two short-term loans was "an integrated step in securing the permanent financing to purchase the home". Therefore, the final loan was "in connection with the purchase" of the principal residence.

The Tax Court in Hunstman did not rule out the deductibility of points on all types of refinance loans. In a footnote, the court held that not all refinancing fell outside Section 461(g)(2). It gave as examples a construction loan to be replaced upon completion by a permanent mortgage loan and a "bridge" loan, depending upon the circumstances.(18) The Tax Court did not define what is meant by a bridge loan -- short-term financing which will be paid off with a long-term loan from a different lender. The Tax Court did not say why Huntsman did not fall into this category. The Court may have believed that too much time elapsed between the first loan (January 1981) and the final loan (September 1983) for the first loan to be a bridge loan.

It should be emphasized that the Eighth Circuit's decision is not likely to affect the vast majority of taxpayers who refinance their principal residence indebtedness to obtain lower interest rates. The court made clear that it was holding for Huntsman because the final financing was an integrated step in the acquisition process. It cited the Tax Court's concern that allowing Huntsman a deduction for points could be used by taxpayers who refinance for lower interest rates instead of to finalize acquisition. The appellate court noted that obtaining a lower interest rate was not the reason for Huntsman's refinancing.

Therefore, points paid on refinance home loans will generally still be amortized over the life of the loan unless the proceeds are used for home improvements. Points on home loans which are used to substantially improve the principal residence are fully deductible under Section 461(g)(2) in the year paid.(19)

The application of Sections 163(h) and 461(g)(2) to home mortgage points may be illustrated by the following example. Assume Jones purchases a home in 1981 for $100,000 with a 30-year mortgage at an interest rate of 16%. In 1990 the home is worth $400,000 with a principal balance of $75,000. Jones refinances his original loan with a new 10% loan of $250,000 and pays $5,000 in points from his separate funds. Of the $250,000 borrowed, $75,000 is used to pay off the first loan, $50,000 is used for home improvements and the balance is used for personal purposes.

The $5,000 in points is treated as follows. Since one-fifth of the proceeds are used for home improvements, $1,000 of the points are immediately deductible. The $75,000 used to pay existing indebtedness are refinance acquisition indebtedness under Section 163(h)(3)(B). This constitutes 30% of the indebtedness (75,000/250,000 = 30%). Therefore, $1,500 in points (5,000 x .30%) will be amortized over the life of the loan. Because the refinancing was not a step in the acquisition process, it will not meet the Huntsman exception for immediate deductibility. Forty percent of the loan (100,000/250,000) is home equity indebtedness under Section 163(h)(3)(C). Therefore, $2,000 of the points (5,000 x 40%) will be amortized over the life of the loan. The remaining $500 in points will also be amortized over the life of the loan, but subject to the phase out for consumer interest. After 1990 there will no longer be any deduction for consumer interest.


The Huntsman decision will benefit taxpayers who use short term financing as one step to obtaining a permanent loan for home acquisition. These taxpayers will be entitled to an immediate deduction for points. However, taxpayers who refinance to obtain lower interest rates will be required to amortize points over the life of the loan unless loan proceeds are used to substantially improve the principal residence.


(1)For a discussion of what constitutes a principal residence see Reg. 1034-1(c)(3)(i). (2)Donald Wilkerson, 70 TC 240, 253 (1978). (3)Walter Dozier, TCM 1982-569; See also Rev. Rul. 67-297, 1967-2 CB 87. (4)Metropolitan Mortgage Fund, Inc., 62 TC 110 (1974); See also Rev. Rul. 68-650, 1968-2, CB 78. (5)Wilkerson, Supra note 2 at 255, 256. (6)Roger Schubel, 77 TC 701,706 (1981); See also Alan A. Rubnitz, 67 TC 621, 627 (1977). (7)Wilkerson, supra note 2, at 258-259; Newton Burgess, 8 TC 47, 49, 50 (1947); See also Barry Battlestein, 611 F. 2d 952 (CA-5, 1980). (8)Rubnitz, supra note 6 at 629. (9)Richard Heyman, 70 TC 482, 485 (1978). On how to deduct the points see Rev. Proc. 87-15, 1987-1 CB, 624, 625. The portion of Rev. Proc. 87-15 dealing with withheld points on home acquisition mortgages would no longer be appliable in light of Notice 90-70. (10)Section 163(h)(3)(B). (11)Section 163(h)(3)(C). (12)OBRA 1987 Conference Committee Report in CCH, Standard Federal Tax Reporter, Vol. 2, 1990, p. 23, 514. (13)It would be tempting to read Section 163(h)(3)(B) as allowing a full immediate deduction for refinancing points. The reason is that refinanced indebtedness is classified as acquisition indebtedness to the extent of the balance due on the original acquisition loan. Section 461(g)(2) allows an immediate deduction for points paid to purchase a principal residence. There is no difference between acquisition and purchase. Thus, Section 163(h)(3)(B) could be read as putting a refinancing loan on the same footing as the original acquisition loan. The effect of such an interpretation would be to expand the meaning of the word purchase in Section 461(g)(2) to include refinanced indebtedness. However, there does not appear to be any support for such an interpretation. (14)James Huntsman, 91 TC 917,920 (1988), citing the House Report in 1976-3 CB (Vol. 2) at 793. (15)James Huntsman, 90-2 USTC, 50,340, 66 AFTR 2d 90-5020. (16)Snow v. Commissioner, 416 U.S. 500, 502, 503 (1974). (17)Huntsman, 90-2 USTC, 50340 at note 6. (18)91 TC at 920 Fn 5. (19)Rev. Rul. 87-22, 1987-1 CB 146, 147 Situation 2.

John C. Zimmerman is a certified public accountant and attorney who is also an assistant professor of accounting at the University of Nevada, Las Vegas. He has an MS degree in taxation and received his JD from Southwestern University School of Law in Los Angeles. He has been published in numerous accounting and law journals.
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Author:Zimmerman, John C.
Publication:The National Public Accountant
Date:Feb 1, 1991
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