Whether obtaining a mortgage to purchase a house or refinance an existing mortgage, it can be very tempting to pay loan discount points in an effort to secure the lowest interest rate possible. While I don’t often advise paying discount points because it is rarely in the client’s best interest, especially in refinance transactions, the good news is that if you decide to pay points, any points you pay may be deductible on your income tax return. However, as is typical with the IRS and any tax deduction, the rules regarding how and when you can deduct any points paid in a refinance transaction are cryptic at best, and very different from paying points when you purchase a home.
Under Section 163 of the IRS code, and spelled out in IRS Publication 936 (2015), loan discount points paid in connection with a mortgage loan secured by real estate are tax deductible as long as they are paid to secure the interest rate and are not for a specific service performed in connection with a mortgage loan, such as appraisal fees, inspection fees, title fees, attorney fee, etc…
For points paid in a refinance transaction to be deductible on your income tax return the following tests must be met:
- Your loan is secured by your primary residence.
- Paying points is an established business practice in the area where the loan was made.
- The points paid were not more than the points generally charged in that area.
- You use the cash method of accounting, which means that you report income in the year you receive it and deduct expenses in the year you pay them.
- The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
- The funds you provided at or before closing were at least as much as the points charged. You cannot have borrowed these funds from your lender or mortgage broker.
Unlike points you might pay when you buy a house, generally, points you pay when you refinance a mortgage are NOT deductible in full in the year you pay them and they are ONLY deductible if an amount equivalent to the points charged is paid in cash (see test #6 above). To be clear, if you paid $3,000 in points in a refinance transaction and you financed all monies involved in your transaction, the points you paid are no longer tax deductible. However, if you paid at least $3,000 from your own funds, regardless of what those funds were used for (i.e., final mortgage payment, property taxes, insurance, etc…), the points are tax deductible.
If you paid points when you refinanced a mortgage you can deduct these points ONLY over the life of the loan (e.g., 10, 15, 20, or 30 years). While your effective cost is still reduced by the tax savings, it will take the entire loan term for you to realize the tax savings. For example, if you paid $3,000 in points and you obtained a 30-year mortgage you would only be able to deduct $100 per year for 30 years ($3,000 ÷ 30).
Let’s take this example one step further. A little known exception in IRS Publication 936 says if you refinance a mortgage that you paid points in cash at closing and you deducted $100 per year you can deduct the remainder of the non-deducted points in the year the subsequent refinance occurred. For example, if the last time you refinanced your mortgage you paid $3,000 in points and three years later you refinance again you can deduct the remaining $2,700 in non-deducted points in full.
Another little known exception says if you use part of the refinanced mortgage proceeds to improve your primary residence and you meet the first six tests listed above, you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. You can deduct the rest of the points over the life of the loan.
These cryptic rules and various exceptions should be strong evidence of the value in working with a professional who can help you navigate the shark infested waters of the mortgage and tax world.
If you are considering paying discount points to secure a lower interest rate, regardless of whether you are purchasing or refinancing a house, and you would like to know what criteria you should consider and if it makes financial sense to do so call us to schedule a time to discuss your specific situation.
There are a number of caveats to the tax deductibility of loan discount points, such as the Alternative Minimum Tax, which are beyond the scope of this blog post.
This blog post is intended to provide introductory information to the subject matter covered. Neither the company, the advisor, nor their representatives offer tax or legal advice. Consult your attorney or tax advisor as to the applicability of this information to your specific circumstances and for complete up-to-date information concerning federal and state laws in this area.
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