Seller-paid points: opportunities for accountant/client interaction.
As a result of Revenue Procedure 94-27, we shall investigate the consequences of seller-paid points to both buyer and seller. One must note that there is no requirement that the buyer deduct seller-paid points. We shall evaluate both the current and possible future tax consequences of deducting these points. In particular, amending previously filed returns in order to include seller-paid points (as part of one's itemized deductions) may have tax consequences for the buyer in future years. Examples will be presented to illustrate these consequences.
Requirements for Deducting Seller-Paid Points
In order for purchasers to deduct seller-paid points, five conditions must be met. They are:
* The home purchased must be the buyer's principal residence. Regulations are retroactive to all settlements occurring after December 31, 1990.
* The settlement sheet (HUD-1) must clearly indicate a credit given for loan origination or discount points paid by the seller.
* The points have to be computed as a percent of the mortgage principal, not the sales price.
* Points must be in line with local area business practice.
* To be eligible for the deduction, the purchaser must be solely responsible for making the mortgage payments.
Situations Where the New Rule Does Not Apply
Revenue Procedure 94-27 does not apply in the following situations:
* To the extent that the points are allocable to the portion of a mortgage exceeding $1,000,000.
* To points paid for loans obtained for the purpose of improvement (rather than acquisition) of a principal residence.
* To points paid to purchase a residence other than the taxpayer's principal residence (e.g., a second home, investment property or business property).
* To points paid on a refinancing, home equity loan or a line of credit.
Procedure for Deducting Seller-Paid Points
In order for the buyer to deduct the seller-paid points, the buyer must itemize(1) and include points paid as part of itemized deductions on Federal form Schedule A. The points should be reported to the buyer from the mortgage company on IRS Form 1098. As mentioned previously, Revenue Procedure 94-27 was made retroactive to January 1, 1991. Therefore, taxpayers who purchased residences in 1991, 1992 and 1993 and who did not deduct seller-paid points may be able to amend their returns to include these points as part of itemized deductions.
Those taxpayers who are eligible to amend income tax returns (from years as early as 1991) file IRS Form 1040X with the term "Seller-Paid Points" written in the upper right-hand corner of the form. Also, a copy of Form HUD-1 (Uniform Settlement Statement, showing the amount of points paid by the seller in connection with the transaction) should be attached to the amended return. Amended state and/or local income tax returns may also need to be filed.
Practitioners should check their client lists to see who could be eligible to amend their returns. However, the decision to amend one's return may depend on several factors (as will be discussed shortly). The most important question is whether the additional points, together with other itemized deductions, exceed one's standard deduction for the year of purchase. If not, then it probably does not make sense to amend one's return. The effect to the seller on seller-paid points (deducted by the buyer) is not clear. This latter point will be discussed in more depth in the next section.
Tax Consequences for the Seller
In the past, seller-paid points were classified as a selling expense in determining the amount realized from the sale. These points therefore reduced the seller's realized gain. However, the IRS has not addressed the issue of the impact to the seller on seller-paid points as a result of Revenue Procedure 94-27. It is obvious that both buyer and seller cannot take advantage of seller-paid points. Does this mean that a seller must amend a past return (reflecting a higher sales price and realized gain) if the buyer amends a past return to include the seller-paid points? While it seems logical that the seller should amend these returns, no official IRS guidance has been issued until now. The following example illustrates the effect to the seller when the buyer does not deduct seller-paid points.
Larry is selling his principal residence to Kathy. He plans to purchase another principal residence within the next year. In connection with the purchase, Kathy is applying for a mortgage in the amount of $150,000 and is being charged two loan origination points, or $3,000. Larry has agreed to pay the points for Kathy. As a result of paying these points, Larry's realized amount from the sale has been lowered by $3,000, or to $197,000. Kathy does not deduct these points on her return. Assuming Larry's cost basis in the old residence is $100,000, his realized gain from the sale (assuming no other selling or fix-up expenses) is $197,000 less $100,000, or $97,000. In order to avoid tax on his realized gain, Larry must purchase a new principal residence costing at least $197,000 within two years of the settlement date of the sale of his old principal residence.(2)
Tax Consequences for the Buyer
Seller-paid points in connection with a buyer's mortgage loan will be treated as paid directly by the purchaser from funds that have not been borrowed for this purpose. The purchaser will be able to deduct these points as part of the home mortgage interest itemized deduction(3) on his or her income tax return for the year of purchase. In the event that the purchaser does subtract these points, the amount deducted must be subtracted from the purchase price in order to establish the cost basis in the new residence. The next example illustrates this procedure.
Joanne purchased her principal residence at a cost of $300,000, obtaining a mortgage of $200,000. The seller paid three points, or $6,000, as part of the settlement costs. Joanne paid other closing costs amounting to $10,000. Her cost basis in the new residence is $200,000 plus $10,000 less $6,000, or $204,000.
How Accountants Can Assist Their Clients
Revenue Procedure 94-27 was released in early April, 1994. From the perspective of both the accountant and client, the timing was not optimum. In particular, at the time of the release, accountants were busy preparing 1993 income tax returns for their clients. Many taxpayers who read the IRS pronouncement called their accountants to request more information. Accounting offices (including the author's) were deluged with phone calls. Our office informed clients that no action would be taken on past and present income tax returns until we had an opportunity to read and analyze the revenue procedure. We also informed clients that 1991 income tax returns (the earliest returns affected by the ruling) could be amended as late as April 15, 1995 (three years from the original filing deadline of April 15, 1992). There was therefore no immediate need to amend 1991 returns.
Shortly after April 15, we made a list of clients who could possibly be affected by Revenue Procedure 94-27. We also came up with a list of questions and/or potential problems that could be generated as a result of filing amended returns. Among the problems and questions:
* If the client used the standard deduction on his or her original return, will the seller-paid points generate enough itemized deductions to exceed one's standard deduction?
* If the client used the standard deduction on his or her original return and received a state income tax refund, then the state income tax refund was not taxable(4) in the year of receipt. However, if the client has sufficient itemized deductions (using state and local income taxes as part of the itemized deductions), then the state income tax refund is taxable in the year of receipt(4) as the following example illustrates:
Donald filed his 1991 Federal and state income returns using the standard deduction. His itemized deductions (including state and local income taxes) totaled $2,500, $900 less than the standard deduction of $3,400 for a single taxpayer in 1991. He filed his state income tax return in the spring of 1992, receiving a refund of $1,000. He is in a 28% tax bracket.
Donald also purchased a principal residence in 1991 with the seller paying a total of $3,000 in loan discount points at settlement. As a result of Revenue Ruling 94-27, Donald may amend his 1991 Federal income tax return and include the $3,000 as part of his itemized deductions. By including the $3,000, Donald's itemized deductions total $5,500 ($2,500 plus $3,000), exceeding his standard deduction of $3,400 by $2,100. He amends his 1991 Federal return and receives a refund of $588 (28% of $2100) plus interest. However, because he itemizes, state income tax refunds are taxable in the year of receipt. Donald must therefore file an amended 1992 Federal income tax return to include the $1,000 state income tax refund.
* If the client bought a principal residence in which the seller paid the points and the residence is subsequently sold, how will deducting the points affect the realized gain? This is particularly important if either a less expensive or no principal residence was purchased within the required two year period.(2)
Sally bought her first principal residence in 1991 for $300,000, obtaining a $200,000 mortgage. As part of the closing costs, the seller paid three points, or $6,000. Sally paid other dosing costs amounting to $10,000. She made no capital improvements to her residence. Her cost basis (without deducting the seller-paid points) is therefore $210,000. Sally sold her residence in 1993 at an adjusted sales price of $213,000. Sally purchased another principal residence in 1993 at an adjusted purchase price of $205,000.
In accordance with Internal Revenue Code Section 1034, Sally has a recognized capital gain of $3,000 (the lesser of $213,000 less $210,000 and $213,000 less $205,000). However, should Sally decide to deduct the $6,000 of seller-paid points on her amended 1991 income tax return, her cost basis in the residence is decreased from $210,000 to $204,000. Her taxable gain resulting from the sale of the residence is increased to $8,000 (the lesser of $213,000 less $204,000 and $213,000 less $205,000). She therefore must file an amended 1993 income tax return and pay capital gains tax on the additional capital gains of $5,000 ($8,000 less $3,000).
* If a taxpayer was married and filed a joint return for the year of purchase but subsequently divorces, will his or her former spouse consent to file an amended return to include seller-paid points?
* Does it make more sense to amortize the seller-paid points rather than expensing them in the year of purchase?
* What effect does the ruling have if the taxpayer converted the residence to a rental property subsequent to living there for a period of time?
These are a few of the questions that taxpayers and their accountants must ponder in order to determine if deducting seller-paid points makes economic sense. Other problems or questions (e,g., effect on state income taxes, if any) may have to be addressed as well. As a result of Code Section 1034 and the deferral of capital gains tax, the decision to deduct seller-paid points may therefore have an effect for as long as the taxpayer owns a principal residence.
Summary and Conclusions
We have presented some of the issues and consequences related to the recently released Revenue Procedure 94-27. The IRS has reversed its past position and will, under certain conditions, permit purchasers of a principal residence to deduct seller-paid points.
There is no doubt that many taxpayers who purchased residences between 1991 and 1993 (and in the future) will benefit from this ruling. However, because there is no requirement for the buyer to deduct these points (whether in full for the year of purchase or over the life of the mortgage loan), the question of deducting or not deducting these points may not be easy to answer. Furthermore, the consequences to the buyer of deducting the points in one year may affect the buyer's tax liability in subsequent years. It is therefore important that eligible taxpayers carefully discuss these issues with their tax advisors.
Finally, the IRS has not ruled on the consequences to the seller of seller-paid points. Both buyer and seller cannot take advantage of the seller paying points for the buyer. It may be up to the respective parties to negotiate who shall be able to utilize the deduction. Seller-paid points are therefore another potential bargaining instrument between buyer and seller.
1 Internal Revenue Code Section 163
2 Internal Revenue Code Section 1034
3 Internal Revenue Code Section 461 (g)(2)
4 Internal Revenue Code Section 11
Edward A. Zurndorfer is enrolled to practice before the Internal Revenue Service. He is also accredited in accountancy and taxation by the Accreditation Council for Accountancy and Taxation (ACAT). A member of NSPA, he has published several articles on individual and small business taxation in professional tax journals.
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|Author:||Zurndorfer, Edward A.|
|Publication:||The National Public Accountant|
|Date:||Sep 1, 1994|
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