With the Federal Reserve System signaling a possible change in policy, including a willingness to allow interest rates to rise, many potential home buyers may be tempted to make their move.
If you are considering the purchase of a new home, you’re undoubtedly aware that mortgage loans come in many varieties.
One concept that may be unfamiliar to first-time home buyers is the term “points.” The term is used to describe certain charges you pay to obtain a home mortgage.
One point equals one percent of the mortgage loan. Generally speaking, the higher the number of points you pay to obtain the mortgage, the lower the stated annual interest rate on the loan. So, if you have the cash available at closing, you may be able to negotiate a higher one-time payment of points in exchange for a lower annual interest rate that you would otherwise pay every year for the next 30 years.
From an income tax perspective, points are prepaid interest and may be deductible as home mortgage interest, if you itemize your deductions. If you can deduct all of the interest on your mortgage, you will likely be able to deduct all of the points paid on the mortgage. If your acquisition debt exceeds $1 million or your home equity debt exceeds $100,000, you cannot deduct all the interest on your mortgage, and the deduction of points will be similarly limited.
You can deduct the points in full in the year they are paid if all the following requirements are met:
1. Your loan is secured by your main home (the one you live in most of the time).
2. Paying points is an established business practice in your area.
3. The points you paid were not more than the amount generally charged in your area.
4. You use the cash receipts and disbursements method of accounting (most people do).
5. The points were not paid for items usually stated separately on the settlement sheet, like appraisal fees, inspection fees, title fees, attorney fees or property taxes.
6. The funds you provided at or before the closing, plus any points the seller paid, were at least as much as the points charged. (You cannot have borrowed the funds from your lender or mortgage broker to pay the points.)
7. You use your loan to buy or build your main home.
8. The points were calculated as a percentage of the principal amount of the mortgage.
9. The amount is clearly shown as points on your settlement statement.
You can also fully deduct, in the year paid, points paid on a loan to improve your main home if requirements No. 1-No. 6 are met. Points that do not meet these requirements may be deductible, but, if so, the deduction must be spread over the life of the loan.
Points paid for refinancing generally can only be deducted over the life of the new mortgage. However, if you use part of the refinanced mortgage proceeds to improve your main home, and you meet the first six tests stated above, you can fully deduct the part of the points related to the improvement in the year you paid them. You can deduct the rest of the points over the life of the loan.
Points charged for specific services, such as preparation costs for a mortgage note, appraisal fees or notary fees, are not interest and cannot be deducted.
Points paid by the seller of a home cannot be deducted as interest on the seller’s return, but they are a selling expense that will reduce the amount of gain realized. Points paid by the seller may be deducted by the buyer, provided the buyer subtracts the amount from the basis or cost of the residence. Points paid on loans secured by a second home can be deducted only over the life of the loan.
Beginning in 2013, you may be subject to a limit on some of your itemized deductions, including points, if your adjusted gross income exceeds $300,000 for a married couple or $250,000 for others.
For more information on points, refer to Publication 936, Home Mortgage Interest Deduction.