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Deducting a prepayment penalty

George SaenzDear Tax Talk,
I recently had to refinance my second mortgage and equity line on my house to get the joint debt ownership to a single debt ownership. Even though I kept the mortgage note and equity in the same bank, they charged me a prepayment penalty. This is clearly indicated as such on the closing documents, and the prepayment fee is indicated in the original mortgage as a point basis. Is the prepayment amount deductible as it is expressed as points and was rolled over into the other note taken with the bank? -- Marty

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Dear Marty,
A prepayment penalty on a home mortgage is generally deductible as interest expense when paid. However, based on what you're telling me, it sounds like you refinanced the prepayment penalty into the new home mortgage.

In order for the prepayment penalty to be deductible, you would have had to actually pay it at the time of closing on the new loan. For example, if the prepayment penalty was $3,000 and you had out of pocket costs of at least that amount at the closing of the new loan, you can deduct the prepayment penalty.

If instead, the prepayment penalty was covered by additional borrowing, then no payment took place and you need to spread the deduction over the term of the new loan. To continue the example, if you took out a 30-year loan then you would deduct $100 annually for the prepayment penalty.

The same rule applies to points paid to purchase a new home. Your out-of-pocket expenses at closing, including earnest money, has to be more than the charges for points in order that you get a full deduction.

-- Posted: Oct. 25, 2002




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