Among the biggest tax benefits that the federal government gives homeowners are deductions for mortgage interest and points. Here's a closer look:
Mortgage interest. Interest on mortgage loans on a first or second home is fully deductible, subject to these limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married, but file separately, the limits are split in half.
An acquisition loan is one that is used to buy, construct or substantially improve your home. If you refinance for more than the outstanding debt, the excess amount does not qualify as an acquisition loan unless you use all the excess to improve your home.
For example, say that several years ago you bought your house for $200,000 and obtained a mortgage (or deed of trust) for $150,000. Over time, you have reduced your mortgage debt to $125,000, while the value of your house has increased to $400,000.
Because rates were low last year, you refinanced, taking out a mortgage for $210,000. Your acquisition indebtedness, however, remains $125,000. The additional $85,000 that you took out of your equity does not qualify as acquisition indebtedness, but because it is less than $100,000, it qualifies as a home equity loan and it is deductible.
However, if you borrowed $250,000, you would have $125,000 of acquisition indebtedness and $125,000 of other debt. Only the first $100,000 of that $125,000 would be deductible; the rest would be treated as nondeductible personal debt.
The IRS has made it clear that you do not have to take out a separate home equity loan to qualify for this aspect of the tax deduction.
Points. When you shop for a mortgage, you will get a lot of information. One of the important concepts you should understand is that of "points."
Points can go by different names, such as loan discounts or origination fees. Regardless of what they are called, they represent money that you, the borrower, must pay. The payment is usually upfront, in cash, because it generally is not included in the loan amount.
One point is equal to 1 percent of the loan amount. Lenders can charge as many points as they want, but at some level, the loan becomes usurious and potentially illegal.
Lenders take risks. They lend money to strangers, who may or may not be able to repay in full. To secure repayment, the lender requires the borrower to sign a deed of trust (the mortgage document) under which the house is put up as collateral (security) to guarantee full payment. Despite the great appreciation of home prices in recent years, houses can decrease in value, which makes the lender's security potentially more risky.
The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge.
Many people do not shop around for the best mortgage deal; they take the lender's statements about credit status on blind faith. It is often possible to get a better interest rate -- or fewer points -- from another source.
Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS used to require that the borrower write a separate check to the lender for points; in recent years, the IRS seems to have backed off that position. However, it still makes sense to write a separate check at closing -- or at least have the settlement statement (the HUD-1 form) clearly reflect the number and amount of points you are paying.
If you pay points to obtain a refinance loan, however, in most circumstances those points are not deductible in full for the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your mortgage loan. For example, say you refinance and obtain a loan in the amount of $210,000. To get this new loan, you are required to pay two points, or $4,200. If your loan is for 30 years, you can deduct only one-thirtieth of the points each year, or $140.
However, should you pay off the loan early, perhaps by selling the houses or refinancing again, the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.
Talk to your potential lenders about trading interest rates for points. Generally speaking, each point that you pay is the equivalent of one-eighth of an interest-rate point. Thus, you may be able to get a loan at 5.625 percent with no points, but a 5.5 percent loan rate with one point.
Seller-paid points. Everything in real estate is negotiable. Often, a potential buyer presents a sales contract to a seller and asks the seller to make financial concessions to make the sale go through. Such concessions could include the seller paying some or all of the buyer's closing costs, the seller giving a cash credit at settlement, or the seller paying some or all of the buyer's points.
The IRS has issued a ruling that these points, generally referred to as "seller-paid points," can be deducted by the purchaser under certain circumstances.
Example: You agree to pay $250,000 for your house and obtain a loan of $200,000. The lender can give you a fixed 30-year conventional loan for 5.75 percent, with no points, or 5.5 percent with two points, or $4,000. If you can persuade the seller to pay the points (make sure the sales contract says the seller is doing so), you should be able to deduct the $4,000 on your income tax return for the year you buy the house.
The settlement sheet is perhaps the most important document you receive at settlement. Keep it forever. It will be your best proof if you are ever challenged by the IRS.
There is one hitch to deducting seller-paid points. The amount of the points paid by the seller will be used to reduce the purchaser's basis price if the purchaser deducts those seller-paid points. In our example, if the purchaser paid $250,000 for the property, and deducted the $4,000 of seller-paid points, the cost basis to the purchaser would be reduced by the amount of the points deducted. The basis would now be $246,000 ($250,000 minus $4,000).
This used to be a major concern. However, under current tax law, it is relatively unimportant. As has been discussed earlier in this series of articles, taxpayers can fully exclude from federal tax up to $250,000 of capital gain ($500,000 for married couples filing a joint return) on the sale of principal residences.
Thus, the tax basis of relatively unimportant -- unless the taxpayer makes a profit that exceeds the statutory dollar amounts.
Next Saturday: Forward and reverse Starker exchanges
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036.
