Some Finer Points of Deducting ‘Points’ : Taxes: These payments to mortgage lender are deductible under certain conditions, but the debate rages on refinancing.

In the good old days, when you borrowed money from a mortgage lender, you were quoted an interest rate and that was all you paid.

If you were buying a house for $70,000, for example, and you were obtaining an 80% loan, you borrowed $56,000 from the lender, and at settlement the escrow company received a check in that amount. Your monthly mortgage payments began shortly thereafter.

When interest rates started to fluctuate greatly in the early 1970s, and began to hit the various statutory usury ceilings, mortgage lenders started to charge borrowers additional cash, which had to be paid upfront to obtain the necessary mortgage funds.

By the mid-1970s, points were a significant--and essential--aspect of all mortgage loans.

Oversimplified, a point can be calculated as 1% of the loan. Thus, if you borrow $56,000 each point is $560.

Generally speaking, unless there are prohibitions on the number of points a borrower can pay (such as with an FHA loan), the lender does not care who pays them. The borrower (buyer) can negotiate with the seller as to who will pay the points and, as a marketing tool, sellers may be willing to pick up all or part of the points to make a sale.

Buyers and sellers of real estate should anticipate the payment of points when they are negotiating a real estate sales contract. The decision of who pays the points must be included in the contract so as to avoid future headaches and uncertainty.

Since points are generally considered interest paid in advance to a lender for the use or forbearance of money, Section 461(g)(2) of the Internal Revenue Code permits points to be fully deductible in the year of payment. There are four basic rules that must be met.

First, the loan must be used to purchase or improve the taxpayer’s principal residence.

Second, the loan must be secured by the principal residence. This means that a loan from a family member or a friend that does not have a security interest (a deed of trust or a mortgage) associated with it will not qualify.

Third, the payment of points must be an established practice in the area in which the loan is made.

Finally, the number of points paid does not exceed the number of points generally charged in the area where the loan is made.

In other words, if the typical number of points charged by lenders in your area is three, the fact that you are able to buy down the interest rate by paying six or seven points will not permit you to deduct more than the three points charged in your area.

There has been a debate raging in Congress for the last several years as to whether points paid to obtain a refinancing mortgage are deductible.

The Internal Revenue Service has taken the firm position that refinancing points are not deductible in the year they are paid because the c o de only permits the deduction of points paid “in connection with the purchase or improvement of . . . the principal residence.”

Instead, if you obtain a 30-year refinance loan, you are only able to deduct one-thirtieth of the points paid each year, rather than the entire amount the first year.

A recent case handed down by the U.S. Court of Appeals for the 8th Circuit has, however, somewhat broadened the deductibility of points for certain kinds of refinancing transactions.

The 8th Circuit held that when taxpayers purchase a principal residence with a short-term loan secured by a mortgage on the residence and subsequently replace the loan with long-term financing, “the permanent mortgage obtained is sufficiently in connection with the purchase of the home” to fall within the provisions of the Internal Revenue Code that permits the deductions of points.

The IRS takes the position that this opinion only applies to taxpayers in Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota--the limits of the 8th Circuit’s jurisdiction.

The ramifications of the court’s opinion have yet to be felt in other parts of the country, and thus a taxpayer who deducts refinancing points in the year they are paid in other jurisdictions faces the potential wrath of the IRS.

Obviously, if you refinance your existing loan to pay for improvements, a portion of the points can be deducted under a formula that allocates the cost of improvements over the original loan.

However, recently the IRS did make a minor concession to taxpayers. Before 1991, to deduct points even on the purchase of a principal residence, it was necessary to pay these points separately at closing.

Often, lenders give the escrow agent a net check, whereby the points have already been deducted from the loan proceeds. In other words, if you borrow $100,000 and have to pay three points, $3,000 is deducted when the lender sends the escrow agent the check for $97,000.

Under those circumstances, prior to 1991, the IRS--and the Tax Court--took the position that these points were not deductible, because they were not “separately paid.”

However, in a recent change of heart, the IRS has abandoned the need for paying the points separately, and thus those points can be deductible in the year they are paid, provided the other tests outlined above apply.

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