Making Sure Your Loan Points Pay on Tax Bill

QUESTION: We are about to close on our new house, and the lender is charging us two points. We are getting conflicting opinions on whether we should pay them separately or not.

ANSWER: Because this is a confusing area of the law, and because the Internal Revenue Service does not like people to deduct points, my suggestion is that you should pay your points separately, whether or not it is legally required.

First, let me explain what “points” are.

It used to be that when you borrowed from a mortgage lender, you were quoted an interest rate and that was all you paid.

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

Oversimplified, a point is 1% of the loan. Thus, when you borrow $50,000, each point will cost you $500.

Generally speaking, points are deductible in the year they are paid. The IRS takes the position that points on a home mortgage are deductible only if the loan is for the purchase or improvement of your principal residence, and only if 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 points, the IRS may object to a deduction of the additional four points.

A mortgage lender handles the issue of points in one of two ways. An example:

You are buying a house for $200,000, and are borrowing $150,000. The lender is going to charge two points, or $3,000, for the loan. The lender can either send a check for $150,000 to the escrow company handling the sale with instructions that the borrower pay the $3,000 from the loan proceeds or send the escrow company a net check of $147,000.

In 1981, the U.S. Tax Court threw a monkey wrench into the issue of the deductibility of these mortgage points. The ruling held that when points are subtracted from loan proceeds by the lender (for example, the lender gives a net check at settlement) 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 reality. The loan may never be repaid, and thus the court said that the taxpayer has parted with nothing more than a promise to pay.

I think this opinion is highly legalistic, without really considering the realities of the marketplace.

Since the Tax Court has spoken on this issue, however, to get around this situation borrowers were always advised that they have to write a separate check for the points at escrow, to demonstrate that they have in fact paid the points separately.

On Nov. 9, 1990, many experts believed that the IRS changed the rules effective Jan. 1, 1991. In a notice (90-70) the IRS stated that in view of standard commercial lending practices, “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.”

However, there are many analysts who have indicated that to be on the safe side, points still must be paid separately at settlement. It is next to impossible to get most mortgage lenders to send a gross check to settlement. Lenders clearly want to “play the float” and will usually send the net check, having deducted the points up front.

The commentators who have analyzed this issue have indicated that the Internal Revenue Service does not have the authority to overturn the 1981 Tax Court opinion. These commentators have further stated that the IRS notice was only dealing with reporting requirements, and was not changing the law.

The U.S. 9th Circuit Court of Appeals issued an opinion a few months ago that confirms the Tax Court decision. According to the Court of Appeals, points must be paid to the lender to be able to deduct those points in the year they are paid.

“A deduction from the proceeds is not payment,” the court said.

The 9th Circuit opinion is not being formally published, and legally cannot be cited as legal precedent. However, the 9th Circuit is an important court, and covers California, Arizona, Alaska, Hawaii, Nevada, Oregon, Washington, Idaho and Montana.

To be on the safe side, it is recommended that you pay the points separately when you go to closing. Even if you have to write a check to the escrow company, write that separate check exclusively for the amount of the points that are paid, and label the check as “points paid at settlement.”

In this way, if you are ever audited, you can at least prove that you have paid your points separately, and if you meet all of the other requirements for the deductibility of points, the IRS should not be able to sustain a challenge.