Deducting Points

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When you buy a house, you often have to pay points to the lender, in order to get your mortgage. Each point equals 1% of the loan balance. Points can usually be deducted, because they are considered a prepayment of the mortgage interest, which is generally deductible. Other terms for points are:

• Loan origination fees (including VA or FHA loan origination fees)
  
• Maximum loan charges
  
• Loan discount
  
• Discount points
  
• Premium charges

Points may be deductible in full in the year you paid them, or you may be required to deduct points proportionately over the life of the loan. Which method you must use depends upon the purpose of the underlying loan.

Points that are Fully Deductible in the Year Paid

If you paid points for a loan to purchase your main home, you can deduct all your points in the year you paid them, provided that you meet all these criteria:

• The points are paid on a loan secured by your main home (the one you live in most of the time).
  
• Payment of points is customary for the area in which you purchased your home.
  
• You have not paid more than the points generally charged for your area.
  
• You use the cash method of accounting (most people do). Using the cash method means that you report income in the year you receive it and deduct expenses in the year you pay them.
  
• The points are computed as a percentage of the loan amount.
  
• Points are clearly identified on the settlement statement and are not paid in place of other fees.
  
• Either you pay an amount equal to the points from your own funds, or the seller paid the points.
  
• The loan was used to buy, build, or improve your home.
  
• You put cash into your home purchase in an amount at least equal to the points you were charged.

If the points paid on your loan were paid by the seller of the home you purchased, you may deduct those points provided that all the above rules are satisfied. In this case, you must also reduce your tax basis in the home by the amount of seller-paid points. This means that when you eventually sell your home, the cost you use to determine the amount of profit you made on the sale will be reduced by that amount.

Points that Must Be Deducted Over the Life of the Loan

Certain points cannot be deducted in full in the year paid, but instead must be deducted over the term of the loan. This is called amortization. For example, for a 30-year loan, you can deduct 1/30th of these points each year.

Points that must be amortized are:

• Points paid on a mortgage secured by your second home
  
• Points paid on a home equity loan taken out to do something other than buy, build, or improve your home (for example, to pay for your child's college expenses)
  
• Points paid to refinance a loan

Any amount of points remaining when the loan is paid off may be deducted in the year of payoff.

Points You Cannot Deduct

You cannot deduct points paid on loans for personal-use properties other than your principal residence (for instance, a vacation property).

Also, you cannot deduct most of the fees shown on your settlement statement. But these charges are generally added to your basis in the property (the total cost of the property, for tax purposes). The higher your basis, the lower the amount of gain you must report when you sell the property (or the greater the loss), therefore reducing the taxes on the sale.

See IRS Publication 936: Home Mortgage Interest Deduction, for additional information covering the deduction rules for points.