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01/15/08: Mortgage Interest Deductions

HOUSING COUNSEL

By Benny L. Kass

The avoidance of taxes is the only intellectual pursuit
that carries any reward.


John Maynard Keynes

“But it is deductible”!

How often have we heard these words when deciding what kind of a mortgage loan to take? What exactly does deductible mean? 
You plan to purchase a condominium for $300, 000 and put $30,000 (10 percent) down.

You are searching for a $270,000 loan. One lender has offered you a fixed rate 30 year mortgage at 6 1/4 percent, with a monthly payment of $1662.45. Another lender is trying to convince you to take a 3 year adjustable rate mortgage (ARM) which will stay fixed for three years at 5.5 percent interest. The monthly mortgage payment for the first three years will be $1533.04.

Keep in mind that these numbers only reflect principal and interest, not taxes and insurance.

You analyze the numbers and see that there is a difference of $129.41 per month between the two loans. But that’s not the end of your inquiry. You know that you are in the 25 percent income tax bracket, meaning that you are married and jointly you earn between $61,301 and $123,700.

That means that for every dollar you pay in mortgage interest, you can deduct 25 percent of that on your income tax return. So when you plug in these deductions, the difference between the two mortgages now drops to $97.65 a month.

This is an important aspect to consider when you shop for a mortgage loan. In our example, you have to ask yourself “is the monthly savings of $83.22 for the three year ARM really worth it, when my loan may be considerably higher when that ARM is recalculated based on the then current market conditions?

Thus, tax considerations are extremely important – both before you buy and then when you are preparing to file your 2006 income tax return.

Let’s look at two aspects of interest deduction:

Mortgage Interest: Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married, but file separately, the limits are split in half.

You must understand the concept of an acquisition loan. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home.

Let us look at this example: Your current mortgage balance is down to $200,000, but because of the tremendous appreciation over the past few years, your house is now worth $600,000. You would like to refinance and pull out some money.

Based on your credit and the equity in your house, your lender is prepared to give you a mortgage loan of $450,000. That sounds great, but keep in mind that you will only be able to deduct interest up to $300,000. (acquisition indebtedness of $200,000 plus $100,000 home equity)

The Internal Revenue Service has made it clear that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. The remaining interest is treated as personal interest, and unfortunately is not deductible.

Points:

When you shop for a mortgage loan – which is something every potential home buyer should do – you will be given a lot of information. One item which you must understand is the concept of “points”.

Each point is one percent of the amount of your mortgage loan. So if you were to borrow $450,000, each point would cost you $4,500.00. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and may represent what is commonly known as “loan sharking”.

Typically, for every point you pay a lender, you should be able to reduce your interest rate by 1/8 of a percent. However, since interest rates were extremely low in the past few years, borrowers have not wanted to pay extra money just to get an even lower mortgage interest loan.

Points are often disguised with different names -- such as loan discounts or origination fees -- but regardless of their name, they represent money which you -- the consumer -- must pay. And the payment is usually up-front, in cash, since it generally is not included in the loan amount.

Lenders take risks. They lend money to a stranger, who may or may not be able to re-pay the loan in full. To secure repayment of the loan, the lender requires the borrower to sign a deed of trust (the mortgage document) whereby the house is put up as collateral (security) to guarantee full payment of the loan. When home prices are rising, the lender has little risk, but now that it appears that prices are leveling off (and foreclosures are on the rise) this makes the lender’s security potentially more risky.

The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge. But many consumers do not shop around to get the best mortgage deal; they take the lender’s statements about credit status on blind faith. It is often possible to get a better interest rate -- or less points -- from another lending source.

I suspect that as we move into 2007, we will start to see more loans being offered with points.

Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS originally required that the borrower write a separate check to the lender for these points; in recent years, the IRS seems to have backed off of this position. However, it still makes sense to have the settlement statement (the HUD-1) clearly reflect the number and amount of points you are paying.

If you pay points to obtain a refinance loan, however, in most circumstances those points are not deductible in full for the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your mortgage loan. For example, you refinance and obtain a loan in the amount of $450,000. To get this new loan at a reduced interest rate, you opt to pay one point -- or $4,500. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $150.00. However, should you pay off this loan early, either by selling your house or refinancing again, the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.

Seller-paid points:

Everything in real estate is negotiable, especially in a slow market.. Often, a potential buyer presents a sales contract to a seller, and asks the seller to make certain financial concessions in order to make the sale go through. Such concessions include (1) the seller paying some or all of the buyer’s closing costs, (2) the seller giving a cash credit at settlement, or (3) the seller paying some or all of the buyer’s points.

Believe it or not, the IRS has issued a ruling that these points can be deducted by the purchaser. The Service announced that purchasers can deduct, under certain circumstances, points required by mortgage lenders, even if those points were paid by the seller. This is generally referred to as "seller-paid points."

Let us look at your example. You will pay $450,000 for your new house and obtain a loan of $360,000. The lender can give you a fixed 30-year conventional loan for 6 ½ percent, with no points, or 6 1/4 percent if they receive 2 points, or $7,200. If you can convince your seller to pay this sum -- and have your sales contract reflect that the seller is paying this money as points --you should be able to fully deduct the entire payment from your income tax which you file for this year.

Taxpayers are reminded that the settlement sheet is perhaps the most important document received at settlement, and should be kept forever. This will be your best proof if you are ever challenged by the IRS.

There is one major hitch to deducting seller-paid points. The amount of the points paid by the seller will be used to reduce the purchaser's basis if the purchaser now deducts those seller-paid points. In our example, if the purchaser paid $450,000 for the property, and now deducts the $7,200 of seller-paid points, the cost basis to the purchaser is reduced by the amount of the points deducted. In our example, the basis will now be $442,800 ($450,000 minus $7,200).

Here, under current tax law, this may not be a real problem for you. As will be discussed later in this series of articles, taxpayers who live in their house for at least two years can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence.

Thus, the tax basis of relatively unimportant -- unless the taxpayer makes a profit that exceeds the statutory dollar amounts of $250,000 or $500,000.

This information is general in nature. Every taxpayer is unique, with different options and circumstances. You must consult your tax advisor for your particular situation.

(Next: tax implications when selling your house)

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