Seller-paid points now deductible.
Sec. 46 1 (g) (1) provides that interest paid by a cash-basis taxpayer properly allocable to any period (1) for which the interest represents a charge for the use of money, and (2) that is after the close of the tax year in which the interest is paid, must be capitalized and treated as if paid in the period to which it is allocable.
Sec. 461(g)(2), however, provides that Sec. 461(g)(1) does not apply to points paid in connection with debt incurred to purchase or improve a taxpayer's principal residence that is secured by the residence, to the extent the payment of points is an established business practice in the area and the points do not exceed the amount generally charged in that area.
For a buyer to claim a deduction for seller-paid points, all of the following requirements must be met:(5)
* The Uniform Settlement Statement prescribed under the Real Estate Settlement Procedures Act of 1974(6) (Form HUD-1) must clearly designate the amounts as points paid in connection with the loan (e.g., "loan origination fees," "loan discount," "discount points" or "points"), including VA or FHA loans. However, VA funding fees and FHA mortgage insurance fees are not deductible as points.
* The points must be computed as a percentage of the stated principal amount of debt incurred by the taxpayer-buyer, not calculated on the sales price. If the amounts described as points are paid in lieu of amounts that are ordinarily stated separately on the settlement statement (such as appraisal fees, attorney fees or title fees), those amounts are not deductible as points under Rev. Proc. 94-27.
* The amounts paid must conform to established business practices of the area and must not exceed amounts charged in that area.
* The amounts paid must be in connection with the acquisition of a principal residence and the loan must be secured by that residence (i.e., there must be a deed of trust (or mortgage) recorded in local land records).
* Deductibility does not apply to points allocable to principal in excess of the aggregate amount that may be treated as acquisition indebtedness.(7)
* Amounts must be paid directly by the taxpayer, must not come from borrowed funds and must at least equal the amount applied as points at the closing. This amount may include down payments, escrow deposits, earnest money applied at the closing or other funds actually paid over by the taxpayer at the closing. Points paid by the seller, including those points charged to the seller, will be treated as paid directly by the taxpayer from funds that have not been borrowed for the payment of points, provided the buyer subtracts the seller-paid points from the purchase price of the home in computing the basis of the residence. Thus, the seller is treated as having paid points to the buyer, who is then treated as having used that cash to pay the points charged by the lender.
If these requirements are met by a taxpayer purchasing a principal residence after 1990 and before Apr. 4, 1994,(8) the points paid by the seller will be treated as paid and deductible by the buyer only if the buyer subtracts the seller-paid points from the purchase price in computing the basis of the residence. The buyer must reduce his cost basis on the home dollar-for-dollar for the seller-paid points.
Not all points paid by a seller qualify for deduction by the buyer, however. The procedure does not apply to the following:
* Points paid in connection with the acquisition of a principal residence, to the extent the points are allocated to principal in excess of the aggregate amount that may be treated as acquisition indebtedness under Sec. 163(h)(3)(B)(ii).(9)
* Points paid for loans the proceeds of which are to be used for the improvement of, rather than the acquisition of, a principal residence.
* Points paid for loans to purchase or improve a residence that is not the taxpayer's principal residence, such as a vacation property, second home, investment property, or trade or business property.
* Points paid on a refinancing loan, home equity loan or line of credit, even if the debt is secured by the principal residence. Refinancing points are deducted over the life of the loan.
* The deduction is not available to those whose loans exceed $1 million.(10)
Taking the Deduction
The deduction for seller-paid points could mean the difference between itemizing and not itemizing for many taxpayers. If the deduction of seller-paid points places the taxpayer in a position to itemize, all deductions--medical bills, charitable contributions, state and local taxes, and property taxes--must be reexamined.
To obtain the deduction for seller-paid points for tax years starting after 1990, buyers who qualify for the deduction may file an amended return (Form 1040). In general, taxpayers have three years to amend from the date of the original filing of their tax return (i.e., for homes purchased in 1991, amended returns are generally due no later than Apr. 15, 1995; for 1992 purchases, amended returns must be filed no later than Apr. 15, 1996; and for 1993 purchases, Apr. 15, 1997 is the latest filing date.
If a home buyer is filing an amended return to claim a deduction for seller-paid points, he should write "Seller-Paid Points" in the upper right-hand corner of Form 1040X, attach a copy of the settlement sheet (HUD-1) and a Form 2119, Sale of Your Home, showing the revised cost basis of the home. Taxpayers should also consider the possibility of an amended state tax return that may increase their total refund. In addition, the IRS will pay interest on the refund due or reduction in tax liability attributable to the deduction.
Taxpayers who have not yet filed their 1993 income tax returns may claim the deduction for points paid by the seller in 1993 by including the amount paid on line 9a of Schedule A if the points were reported on Form 1098, Mortgage Interest Statement, or on line 10 if the points were not reported on Form 1098.
Treatment of the Seller
The IRS's new position seems to greatly benefit home buyers, but how does the procedure affect sellers? This point was left open, but clearly, the IRS will not allow both the buyer and the seller to benefit from a deduction of points without some type of adjustment, perhaps to the sales price. The question not addressed by the IRS is whether allowing the buyer to deduct seller-paid points will automatically increase the sales price, and the profit, to the seller.
Prior to the release of Rev. Proc. 94-27, a seller reported points paid on behalf of the buyer as selling expenses, thus reducing the gain on sale. Under the procedure, the seller may be required to increase the price of the home to cover the points, but also would increase the selling expenses for points paid.
Example 1: T, a home seller, charges $100,000 for a house and pays no points. T has the same capital gain as a seller who charges $102,000 and pays $2,000 in points. In this case, T still reports the same capital gain, but the buyer would receive the deduction for seller-paid points and would reduce the cost basis of the just-purchased home by the amount of the points.
As an alternative, the seller could automatically increase the sales price, receive no offset for points paid on behalf of the buyer, and thus, effectively increase his profit.
Still another question remains unanswered. If buyers amend their prior-year tax returns to reflect a deduction of seller-paid points, will sellers also have to amend their tax returns based on what their purchasers have decided? The revenue procedure is not clear on how buyers and sellers must coordinate their return positions; further clarification is needed.
The following example illustrates the effect of the new procedure.
Example 2: B pays $300,000 for a house and obtains a $200,000 loan. The lender charges two points, or $4,000. Rather than pay this amount at settlement, B negotiates with the seller, S, to split the points equally. The IRS reasons that S has raised the price of the house by the fees he is expected to pay at settlement.
Until the new procedure, B could deduct $2,000, the points paid at settlement, on his return for the year the property was purchased, but not the remaining $2,000 in points paid by S. However, S could claim the $2,000 in points paid as a selling expense and reduce the gross sales price of the home.
Under the procedure, the buyer also may deduct the seller-paid points as long as he also reduces his cost basis in the home. As noted above, the procedure does not make clear how the seller treats the points paid.
How are seller-paid points handled by a buyer who bought a home in 1991 but did not deduct the seller-paid points, and then sold the home in 1993? First, the buyer would need to file an amended return for 1991, reporting a deduction for the seller-paid points on Schedule A. Assuming the buyer had already filed his 1993 return, he would file an amended return and Schedule D, reporting a larger capital gain. If the buyer is trading up to a more expensive home in 1993, he would not have to amend his 1993 return.
Is the Deduction Good for Every Buyer?
Before taxpayers rush to file amended Federal or state returns to deduct seller-paid points on homes purchased after 1990, they should give serious thought to whether they want to reduce their cost basis in the home, a mandatory result of deducting seller-paid points. Although filing an amended return to deduct seller-paid points may result in an immediate refund of taxes paid or reduction of taxes due, the long-range implications of the reduced basis should be considered. Specifically, a taxpayer who has sold a home he owned for many years and buys a less expensive home with the sales proceeds is faced with a capital gains tax of up to 28% of the profit from the sale. Likewise, a taxpayer who does not purchase a new home is faced with a potential capital gains tax.
Consequently, while a taxpayer who purchased his home after 1990 may get an immediate refund or reduction in taxes by claiming seller-paid points on an amended return, the long-term result is a larger capital gain when he ultimately sells the last house and less cash available from the sale.
To Deduct or Not to Deduct?
In Example 2, deduction of the seller-paid points results in a refund of or reduction in 1991 taxes by $620 ($2,000 x 31%). The reduction in cost basis also will increase the capital gain on later sale of the home and reduce the cash available to the seller by $560 ($2,000 x 28%).
If the taxpayer also considers the time value of money, filing an amended return to obtain an immediate refund or reduction in taxes clearly will be the more beneficial choice. At a 10% return on capital, selling the home five years later will result in a $348 reduction in cash available on the sale of the home. This contrasts with the $620 refund in taxes on the initial purchase of the home, a net gain to the buyer of $272.
Still another consideration regarding taking the deduction is whether a capital gains tax will ever be paid. Some taxpayers simply keep trading up to more expensive homes and then, after reaching age 55, become eligible for the Sec. 121 one-time exclusion on capital gains of up to $125,000 on the sale of a principal residence.
Rev. Proc. 94-27 may also affect negotiations of home sales between buyers and sellers.
Example 3: D wants to buy a $250,000 house but lacks the funds for the 20% down payment, the points and the closing costs. D approaches Y, the seller, and asks him to consider increasing the sales price of the house to $256,000 and paying D's mortgage points of $6,000.
If Y agrees to the negotiation, D can complete the deal with significantly less cash. At a $250,000 sales price, D needs a $50,000 down payment, $6,000 in points and $2,000 in other closing costs, for a total of $58,000.
In the revised deal in which Y pays the points, D needs a $51,200 down payment, plus $2,000 in other closing costs, for a total of $53,200. D also gets the benefit of an immediate $6,000 deduction, worth $1,860, assuming he falls in the 31% Federal tax bracket. D's $256,000 cost of the home also must be reduced by the $6,000 seller-paid points, resulting in a basis of $250,000.
While the new procedure is effective for points paid by cash-basis taxpayers for tax years beginning after 1990, lenders who are required to report information under Sec. 6050H(11) and Rev. Proc. 92-11(12) need not apply those requirements to seller-paid points received before 1995.
Home buyers are provided relief in Rev. Proc. 94-27 that allows them to deduct seller-paid points, retroactive to tax years starting in 1991. If a buyer deducts seller-paid points, the cost basis of the home must be reduced by the same amount. Buyers may amend prior-year returns to obtain the deduction for seller-paid points. If a buyer has not filed his 1993 income tax return, the points are deducted on Schedule A.
Home buyers who are considering deducting seller-paid points must plan accordingly:
* Keep records of the settlement sheet (Form HUD-1) indicating costs paid by the buyer and seller.
* Compare the value of the deduction for seller-paid points against the larger capital gain on the later sale of the home.
* Consider whether capital gains tax will ever be paid on a sale of the home.
* Maintain complete housing cost records for improvements and additions to establish basis at the time of sale. Every allowable improvement made before the sale of the home reduces capital gain exposure; in contrast, seller-paid points reduce the owner's cost basis.
The IRS's new position will serve as a boon for many taxpayers, creating a refund or reduction of taxes due, or placing the taxpayer in a position to itemize. While the buyer may meet all requirements for the deduction of seller-paid points, and anticipate a refund windfall, the deduction may not be the right choice for every home buyer. Several issues must be considered before automatically deducting seller-paid points:
* Will the deduction of seller-paid points place the buyer in a position to itemize?
* Will a reduction of the cost basis of the home result in a larger capital gain on later sale?
* Will capital gain ever be reported?
* How will state tax returns be affected? (1) Rev. Proc. 94-27, 1994-15 IRB 17, modifies and supersedes Rev. Proc. 92-12, 1992-1 CB 663, as modified by Rev. Proc. 92-12A, 1992-1 CB 664. In addition, Rev. Ruls. 57-541, 1957-2 CB 319, and 67-297, 1967-2 CB 87, dealing with the treatment of loan origination fees on FHA and VA loans, do not apply to cash-basis home buyers who satisfy the requirements of Rev. Proc. 94-27 for tax years beginning after 1990. (2) A point, considered to be prepaid interest, is a fee charged by the mortgage lender. One point equals 1% of the loan amount. (3) Sec. 461(a). (4) See "A Few Points About Points: IRS Ruling on Upfront Costs Could Change the Way Homes are Sold and Financed," Chicago Tribune, 4/5/94, at C-9. (5) The requirements of Rev. Proc. 94-27, note 1, are essentially the same as those of Rev. Proc. 92-12, note 1. (6) 12 U.S.C. Secs. 2601 et seq. (7) Sec. 163(h)(3)(B)(i) provides that "acquisition indebtedness" means any indebtedness incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer and secured by that residence. (8) Apr. 4, 1994 is the effective date of Regs. Sec. 1. 12 73-2, regarding payments from a borrower to a lender, or payments between the lender and a third party. (9) Sec. 163(h)(3)(B)(ii) states that the aggregate amount treated as acquisition indebtedness for any period shall not exceed $1 million ($500,000 in the case of a married individual filing separately). (10) Sec. 163(h)(3)(B)(ii). (11) Sec. 6050H requires returns relating to mortgage interest received by any person engaged in a trade or business who receives from any individual interest aggregating $600 or more for any calendar year on any mortgage. (12) Rev. Proc. 92-11, 1992-1 CB 662, provides guidance on who is required by Sec. 6050H(b)(2)(C) to report points, and creates a safe harbor for the amount of points that may be reported when received in connection with the financing of the purchase of a principal residence.
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|Author:||Ross, Ronald S.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1994|
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