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What's the Point(s)? Deductible points and mortgage interest

Mar 19 '01 (Updated Apr 26 '03) Write an essay on this topic.

The Bottom Line What are deductible points and mortgage interest?

As this topic is under taxes, I'll assume the real question is: What is Deductible Mortgage Interest?

As usual in dealing with the IRS, the answer is complicated. The quick answer is that you can deduct mortgage interest if:
(1) You are legally liable for the loan
(2) The mortgage must a secured debt on a qualified home (defined below).
(3) There are dollar limits on the balance of the loan (see balance limits, below).
(4) The payment must be due in the tax year, and actually be paid (this means mailed, in most cases) in the tax year, and cover no more than one year. For almost all of you, your tax year is the calendar year, so I will use the terms interchangeably below. In most cases, interest due on the first day of the year is considered due during the previous year. See timing below, for more tips. Prepaid interest must be amortized over the period covered by the interest.

Any deductible mortgage interest is deducted on Form 1040 Schedule A. If you file a form 1040A or 1040-EZ, you may not take advantage of this deduction. See my review, or possibly my upcoming review under What is a Deduction?, for more details.

Points (which I'm afraid I'll have to define, as lisalexx has a different definition, which is probably correct in the mortgage industry, here) can be amortized (which I'm also going to have to define below, as lisalexx has a different, and almost certainly correct, definition at here) over the life of the loan. Some points on your main home can be deducted immediately, as explained below. I was originally going to move the sections on points to another review under this topic, but I've been informed by the management that that is not allowed.

References

IRS Publication 936 (referred to as the publication below).
IRS Publication 535
Form 6251 and instructions

Legally Liable

This means it must a real debt, and you must be responsible to the lender for payment.

Secured Debt

This means, basically, that the lender can take your home if you fail to make payments -- not just in a general court procedure for non-payment of debt, but specifically as a condition of the loan contract. In additional, whatever recording required by state or local law to perfect the mortgage must actually be done.

Qualified Home

Only your main home or a second home can be a qualified home. A home must have sleeping, cooking, and toilet facilities. In other words, a bedroom, bathroom, and kitchen. It can be a mobile home or boat, in addition to a traditional house, provided it has those facilities. If you have more than 2 homes, there are restrictions on changing the second home during a tax year (which, for most taxpayers, means calendar year).. See the publication for details.

Balance Limits

This will be complicated. You must divide the mortgages (and sometimes individual balances of the mortgages) into three categories. (All specific numeric limits are halved if you file as married filing separately.)

Category A: Grandfathered Debt
Any loan taken out on before October 13, 1987. Note than loans refinanced without increasing the outstanding balance retain their character.

Category B: Home Acquisition Debt
This includes any mortgage debt taken out to buy, build, or improve hour home (which must also be the home that was improved).

Category C: Home Equity Debt
This includes any other mortgage debt, but the restrictions are more complicated.

In any of the following three cases, your interest is fully deductible, and you can skip down to the section starting with AMT.

1. All your mortgage loans are in category A.
2. All your mortgage loans are in categories A and B, and your average balance is no more than $1,000,000.
3. Your average balance in category A and B loans is no more than $1,000,000, your average balance in category C loans is no more than $100,000, and your average loan balance for each home is less than the FMV (Fair Market Value) of that home.

The maximum allowable balance is determined by adding the following three quantities
1. The average balance of all category A loans.
2. The average balance of all category B loans, except that this cannot increase the total of items 1 and 2 above $1,000,000.
3. The lesser of $100,000, and the total (over both homes) of the FMV reduced by the category A and B balances.

If the total average balance of all mortgage loans is less than the allowable balance, then all the mortgage interest is deductible. Otherwise, the amount of deductible mortgage interest is reduced by the ratio of the total average balance to the maximum allowable balance.

Note that there may be an error, either in the publication, or in my interpretation, of this calculation in some fairly common situations: If you have only home acquisition debt, and it totals $1.1 million, then it appears that you need the FMV to exceed $1.2 million in order to deduct the full amount of interest, while, if you could re characterize the amount of category B loans exceeding $1 million into category C, you would only need the FMV to exceed $1.1 million. But no one ever said the law was fair.

Special Considerations

You can choose to declare any mortgage as not being secured by your home. The IRS suggests that you might want to do that if the mortgage would be otherwise deductible, for example, as a business expense. I'll add here that you might want to declare a lower-interest loan as being not an eligible mortgage, because this could increase your allowable deduction. However, you need the consent of the IRS to revoke such a declaration.

AMT (Alternative Minimum Tax) (see my review for what is AMT, and why you should care)

As usual, the rules are different for AMT. In this case, it appears that the grandfather date is July 1, 1982; there appears to be no dollar limits on category B, and category C is ignored. As I base this opinion on two paragraphs in the form 6251 instructions, and I (on my own return) do not use the same allocation scheme as described in the publication -- I just ignore the category C loans for the purpose of calculating the AMT deductible interest.-- seek a tax advisor if this makes a difference to you.

Timing

If you pay interest monthly, you can choose whether to pay the interest due January 1, 2002 in 2001 or in 2002 by deciding when to mail the payment. You can only delay other payments to the next tax year by paying them late (and paying the penalty, which is also deductible). You cannot advance more than one payment. In most cases, you'll probably want to make your January 1 payment before December 31, but, if you cannot itemize deductions for some reason, such as you only purchased your house in December, you can delay that one payment until the next year.

Points

The IRS definition of points is :(some of the) charges paid by a borrower when the borrower takes out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest. (From IRS Publication 535.) Seller-paid points are deductible by the buyer. This has absolutely nothing to do with the definition of Points under the Mortgage subcategory.

In general, points must be amortized over the term of the loan. However, points on a loan to buy (or improve) your main home can be deducted in the year paid if you meet the IRS 9-point test -- in most cases, this means that if the points are an established business practice for that type of loan; the points are not more than the points generally charged; the points are not paid in place of amounts that ordinarily are stated separately on the settlement statement; the funds provided by the buyer, together with points paid by the seller, are at least as much as the points charged; and, if the loan is to buy or build your main home, the points must be a percentage of the principal amount and the amount must be clearly shown on the settlement statement.

Amortization (Amortized)

This, again, has nothing to do with the concept of Amortization in the mortgage category; this just means that the points are deductible in equal amounts over the life of the loan.

Conclusion

I hope this has been of assistance in deciding how to deduct mortgage interest. If you need more information, you can E-mail me, or contact a professional tax advisor or the IRS.

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