Points Ruling Could Be Windfall for Homeowners
An Internal Revenue Service ruling this week could create a bonanza for millions of homeowners, touch off a flood of amended tax filings and change how homes are sold and financed.
The IRS, reversing decades-old practice, ruled that mortgage interest points--one of the biggest up-front costs of closing a home loan--are now immediately deductible even when the seller pays them. Points also are immediately deductible even if financed over the life of the loan, the IRS ruled.
Previously, points that were paid by the seller could not be deducted by the buyer. Points that were financed were usually deducted over the life of the loan.
The IRS ruling is particularly significant because it is retroactive to the beginning of 1991, which could allow millions of homeowners to amend past years’ returns to claim refunds. Roughly 12 million homes changed hands during that three-year period and real estate agents estimate that well over half of those included seller-paid points, said Douglas Duncan, economist with the Mortgage Bankers Assn. of America.
Indeed, a study by the California Assn. of Realtors found that 80% of the home sales completed in 1993 included seller financing of a portion of the buyer’s closing costs. The median amount that sellers paid was $2,500, said Mike Jacinto, vice chairman of the real estate finance committee at the California Assn. of Realtors.
Based on these estimates, the Mortgage Bankers Assn. calculates that the new IRS ruling could free up more than $3 billion in tax deductions.
In addition, the ruling could change the way homes are sold and financed. That’s because buyers would have an incentive to pay more for a home in exchange for having the seller pay their points, financial experts say.
Points are prepaid interest, calculated as a percentage of the loan amount. One point on a $100,000 loan, for example, amounts to $1,000.
Consider a hypothetical home buyer, John, who wants to buy a $150,000 residence, but doesn’t have quite enough cash for a 20% down payment, plus closing costs. John goes back to the seller and says he’d like the seller to increase the sales price of the home to $156,000, but pay John’s mortgage points of $6,000.
If the seller agrees, he’ll still walk away with $150,000--the $156,000 sales price minus the points he agreed to pay in escrow.
John, on the other hand, gets to complete the deal with significantly less cash. When the sales price was $150,000, he needed a $30,000 down payment, plus $6,000 in points and $1,000 in other closing costs--a total of $37,000. In the revised deal, where the seller paid the points, John needs only a $31,200 down payment (20% of $156,000), plus $1,000 in closing costs, or a total of $32,200. In addition, John gets an immediate $6,000 tax deduction, which is worth $1,860 in reduced tax, assuming he is in the 31% federal tax bracket.
Why wouldn’t John simply get a loan that required a lower down payment? Low-down-payment loans generally cost more than loans that are based on down payments of 20% or more. Additionally, because points are prepaid interest, the more points you pay upfront, the lower your overall interest rate on the loan.
Meanwhile, the IRS also has clarified rules about deducting points that were financed by the lender.
For years, tax authorities had maintained that you could deduct points in the year you took out the mortgage only if you paid those points in cash. If the points were financed, you were forced to amortize the cost over the life of the loan.
Now the IRS says that if your cash down payment amounts to as much or more than the cost of the points, you can deduct the points in the year you buy the home. In effect, the IRS is saying that--for tax purposes--the first dollars you put into the purchase of a home are considered deductible points.
Some savvy tax accountants say they had been advising their clients to do that since 1992, when the IRS had “clarified” previous law and tax court rulings, indicating that full first-year deductions were allowable under these circumstances. However, many taxpayers didn’t know about the subtle changes.
However, points paid in a refinance still may not be deducted up-front. They must be written off over the life of the loan.
Anyone who bought a home after 1990 where the seller paid some of the points, or where the points were financed, should review their past years’ tax returns. If you did not get a full deduction for the points, you may amend the previous year’s return by filing a 1040X.
When filing the amended return, attach a copy of your mortgage settlement statement showing the points paid by the seller--or financed by the lender. If the seller paid the points, write “seller-paid points” in the top right-hand corner of the form.
For sellers the rule is a wash. In the past they were able to deduct points that they paid on behalf of the buyer. Now, they just reduce the home sales price by the value of the points the seller pays. For instance, if the sales price is $153,000, but the seller pays $3,000 in points for the borrower, the seller would now just report that the home was sold for $150,000.
