Don't Cheat Yourself
On Mortgage 'Points'

Sept. 30, 2002 -- Federal Reserve Board Chairman Alan Greenspan once poked fun at himself for his long and elliptical answers by quipping: If you think you understood what I just said, you must be mistaken.

I often think of Mr. Greenspan when I'm researching thorny tax questions. If the rules initially sound simple, that means you probably need to take a closer look.

Just consider the rules for deducting home loan "points," which are very much in the news these days because of low interest rates and a tidal wave of home-mortgage refinancings. While the basic rules may seem fairly straightforward, there are several important twists and turns that can cost you money if you're not familiar with them.

Points refer to money you pay up front in exchange for a lower interest rate on your mortgage. One point equals one percentage point of the loan. For example, if you borrowed $300,000 and were charged two points, that translates into $6,000.

Sometimes, points go by other names, such as loan origination fees. Whatever the case, they typically represent a form of pre-paid interest and thus are deductible. But how and when you can deduct them can be surprisingly tricky.

The general rule of thumb is you may deduct all the points you paid in the year you paid them, as long as you meet several qualifications, such as if your loan is secured by your main home and if you use your loan to buy or build your main home. For the rest of the fine print, see IRS Publication 936, which has a handy summary on page six.

But you aren't always required to follow this rule. In some cases, even if you qualify to deduct your points in the year you paid them, it may be better to spread out your deductions over the life of the loan, says Martin Nissenbaum, national director of personal income-tax planning at Ernst & Young.

Suppose a couple paid 1.25 points late one year on a mortgage to buy a home. But like most taxpayers, they discovered they were better off taking the standard deduction for that year, instead of itemizing. (The standard deduction is a flat amount based on your filing status.) Thus, the couple would prefer to take the standard deduction for that year and spread the points over the life of the loan. That's okay, the IRS said in a private-letter ruling issued in 1999. If you pass all the taxing tests, you can choose either to fully deduct the points in the year you paid them, or you may deduct them over the life of the loan.

That's an important choice to keep in mind since about seven out of every 10 federal income-tax returns claim the standard deduction, instead of itemizing. Remember that if you take the standard deduction, you can't deduct your interest costs for that year.

Here is an example from Mr. Nissenbaum of Ernst & Young: Suppose you took out a 15-year loan on Jan. 1 of this year and you paid $2,700 in points. Also let's assume that it's better to take the standard deduction this year than to itemize. In 2003, if you itemize, you could deduct $180 of those points ($2,700 divided by 15) as mortgage interest, he says. And you could continue to deduct $180 each year for the rest of the loan's term. "When you pay off or refinance the loan, you can deduct the points remaining, if any, in that year," he adds.

What about a home-improvement loan? The IRS says you may fully deduct those points in the year you paid them as long as you pass various other tests listed in Publication 936.

The rules are different with points you pay on a loan secured by your second home. In that case, you generally must deduct the points over the life of the loan.

That same general rule applies with refinancings: Generally, those points aren't deductible in full in the year you paid them. Spread them over the life of the loan.

But there can be exceptions. If you use part of the refinancing proceeds to improve your main home and if you meet all the other criteria listed in IRS Publication 936, then you can fully deduct the part of the points related to the home-improvement work in the year you paid it. As for the rest of the points, deduct them over the life of the loan.

For example, if half of the loan is attributable to home-improvement costs, then half of the points would be currently deductible, says Mr. Nissenbaum of Ernst & Young.

Accountants tell me some people make a costly mistake when they refinance several times. Suppose you are refinancing for a second, third or even fourth time. In that case, be sure to deduct any points from the earlier refinancing that you haven't yet deducted. The same idea applies when you sell your home and pay off the mortgage; in that case, any points you haven't yet deducted would be deductible for that year.

It's easy to forget about those deductions -- and thus wind up paying too much in taxes.

Here's an additional wrinkle: Real-estate agents say sellers sometimes pay points for the buyer in order to facilitate the deal. In such cases, the buyer reduces the basis of the home by the amount of the seller-paid points -- and then the buyer gets to treat the points as if he or she paid them. The seller can't deduct those points as interest, but they are "a selling expense that reduces the amount realized by the seller," the IRS says.

Email your comments to rjeditor@dowjones.com.