YOUR MORTGAGE : Points Are Deductible Without Separate Check

QUESTION: I have recently heard that you no longer have to pay your mortgage points by separate check in order to deduct those points. Can you explain this?

ANSWER: The Internal Revenue Service recently promulgated a notice that effective Jan. 1, 1991, taxpayers who obtain a mortgage to purchase their principal residence no longer have to write a separate check for the points, in order for those points to be deductible.

First, let us explain what “points” are.

In the good old days, when you borrowed from a mortgage lender, you were quoted an interest rate and that was all you paid. For example, if you borrowed $50,000, at escrow settlement you received a check (payable to the escrow company) in the amount of $50,000, and your monthly mortgage payments began shortly thereafter.

However, when interest rates started to fluctuate significantly in the early 1970s, and when those interest rates 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.

Although this column will not go into the complex legal question of whether the points that are paid should be included in the overall interest-rate computations, the fact remains that 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, when you borrow $50,000, each point is $500.

Borrowers will often hear a lender quote the point structure as “2 and 1.” This means that the lender will charge the borrower 2 points and charge the seller 1 point for the privilege of making a new mortgage loan. On a $50,000 loan, a “2 and 1” point schedule means that lender will receive $1,500 cash upfront when you go to settlement.

Generally speaking, unless there are prohibitions on the number of points a borrower can pay, the lender does not care where these points come from. The borrower (buyer) can negotiate with the seller as to who will pay the points.

Often, if sellers obtain the price they want, they may be willing to pick up all or a portion of these mortgage points. In today’s market conditions, sellers will often agree to pay all of the points as a marketing tool.

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 real estate contract, so as to avoid future headaches and uncertainty.

All too often, I have seen sellers learn for the last time at closing that they are obligated to pay a point or two when they sell their houses. They ask the legitimate question: Why do I have to pay money to my buyer’s lender? The only answer to that question is that it was negotiated into the real estate contract.

Generally speaking, points are deductible in the year they are paid. The Internal Revenue Service takes the position that points on a home mortgage are deductible only if (1) the loan is for the purchase or improvement of your principal residence, and (2) points are generally charged in the geographic area where the loan is made and to the extent of the number of points generally charged in that area for a home loan.

For example, if three points is the going rate in your area, and you claim seven, the IRS will certainly object.

A mortgage lender handles the issue of points in one of two ways. Let us take this example.

You are buying a house for $200,000 and are borrowing $150,000. The lender is going to charge two points for the transaction--or $3,000--at settlement.

The lender can either send a gross check of $150,000 to the escrow company conducting the settlement with instructions that the borrower pay the $3,000 back to the lender, or the lender can deduct the $3,000 from the loan proceeds and send the escrow company a net check of $147,000, and the borrower pays the $3,000 at close of escrow.

In 1981, the tax court threw a monkey wrench into the issue of the deductibility of these mortgage points. The case (Schubel, 77 T.C. 701) held that when points are subtracted from loan proceeds by the lender (as when the lender gives a net check at escrow), these points are not deductible.

According to the tax court, the taxpayer-home buyer received only the face amount of the loan, reduced by these points. The tax court took the position that the borrower has not paid interest (points), since the loan transaction is structured so that the loan fee is withheld from the lender.

According to the tax court, this principle was based on economic realities. The loan may never be repaid, and thus, the court said, the taxpayer has parted with nothing more than a promise to pay.

In my opinion, this decision made no sense. It really did not make a difference to the taxpayer whether the proceeds are deducted from the loan, or whether a separate check is written at escrow closing. The bottom line is that taxpayers-home buyers pay the points at escrow from their own pockets.

Nonetheless, those were the rules. To get around this situation, borrowers had always been advised to write a separate check for the points at closing, to demonstrate that they in fact paid the points separately.

On Nov. 9, the Internal Revenue Service changed the rules, effective Jan. 1.

Typical of the IRS, however, they did not come right out and say that points no longer needed to be paid separately. Rather, in a notice (90-70) dealing with information reporting on home mortgage financing, the IRS stated as follows:

“In view of standard commercial lending practices, for purposes of this reporting requirement, an amount charged to the mortgagor as points with respect to the acquisition of a principal residence will be treated as paid directly by the mortgagor.”

Thus, the IRS has now put to rest the confusing question of whether points have to be paid separately, and whether they are deductible.

As long as the lender charges points, and the amounts conform to an established business practice of charging points in the area in which the loan is issued and do not exceed the amount generally charged in the area, points are deductible--even though the lender may have given the escrow company a net check.

The IRS made it clear that this relates exclusively to the purchase of a principal residence, leaving the issue of refinancing and home improvements to be determined on a factual, case-by-case basis.

AVERAGE RATES FOR RESIDENTIAL MORTGAGES Average rates for residential mortgages as of April 26, 1991.

Survey Conventional Mortgages Adjustable Mortgages Area 15 Year 30 Year Composite 1 Year Composite National 9.33% 9.63% 9.49% 7.33% 7.64% California 9.59 9.84 9.72 7.80 7.78 Connecticut 9.35 9.63 9.51 7.23 7.53 Wash. D.C. 9.23 9.55 9.41 7.06 7.38 Florida 9.27 9.58 9.44 7.36 7.69 Mass. 9.32 9.62 9.48 7.32 7.74 New Jersey 9.28 9.60 9.45 7.39 7.85 N.Y. Metro 9.37 9.68 9.54 7.38 7.75 New York 9.48 9.78 9.64 7.42 7.73 N.Y. Co-ops 9.65 9.95 9.87 7.72 8.12 Pa. 9.08 9.43 9.26 7.17 7.37 Texas 9.21 9.50 9.36 7.25 7.44

SOURCE: HSH Associates, Butler, N.J.