Points Paid to Refinance Home Must Be Deducted Over Life of Loan--Court

Interest points paid to refinance a home mortgage may not be deducted fully in the year the loan is obtained, the U.S. Tax Court ruled Friday.

The court’s decision, on an 8-3 vote, upheld the position taken by the Internal Revenue Service and means that points must be written off over the life of a home loan. The ruling has no effect on points that must be paid to secure a loan that is used directly to buy or improve a home.

Points essentially are an additional interest charge that some lenders impose to get around laws that limit interest rates. They sometimes are paid by a home buyer, sometimes by a seller.

The Tax Court case, which could be appealed, grew out of a January, 1981, decision by James R. and Zenith A. Huntsman to buy a home in Stillwater, Minn. Instead of a more traditional 20- or 30-year mortgage, they obtained a $122,000 mortgage with a final balloon payment three years later. Before that three years was up, they took out a second mortgage for a $22,000 home improvement loan.

Less than four months before the first mortgage fell due, the Huntsmans refinanced their home with a 30-year loan that was used to pay off the first and second mortgages. To obtain the new loan, they had to pay $4,440 in points, which they deducted on their tax return.

Varied Goals Cited

The IRS disallowed the full deduction on grounds that the new loan was not used to buy or improve the Huntsmans’ home. The Huntsmans were told they could deduct only $148 in each of the 30 years.

The law is unclear, saying that points are fully deductible in the year they were paid only when the loan was used “in connection with the purchase or improvement” of a home.

“In a refinancing transaction, the funds generated by the loans generally are used not to purchase or improve a principal residence but to pay off the loan that is already in existence, and thereby lower the interest costs incurred or achieve some other financial goal not connected directly with home ownership,” Judge Theodore Tannenwald Jr. wrote for the majority.

As a result, the court held, Congress did not mean to allow an immediate full deduction for such points.

The key point was precisely what Congress meant by the words “in connection with.” Tannenwald noted that in its own explanation of the 1975 law, Congress had stated that immediate deduction would not be permitted if a loan was “used for purposes other than purchasing or improving the taxpayer’s principal residence.”

Dissenting judges contended that the ultimate purpose of the Huntsmans’ 30-year refinancing mortgage was to buy their home.

Issue of Intent

“The hard reality is that . . . (the Huntsmans) were locked into a situation which necessitated that they obtain permanent financing (or at least some type of refinancing) within three years of the date of the purchase,” Judge Robert Ruwe wrote for the minority.

When the Huntsmans took out their original loan, Ruwe wrote, it would have been evident to them and their lenders that the mortgage would have to be refinanced. (The couple, with two dependent children, reported an income of about $71,000 in 1983).

“From the standpoint of an ordinary person who is purchasing a home with the proceeds of a large loan, payable three years from the date of purchase, refinancing would be a foreseeable necessity ‘in connection with’ the purchase,” the dissenters contended.