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Is prepayment penalty tax-deductible?

Dear Tax Talk,
I paid a prepayment penalty when I refinanced my mortgage. Is this penalty tax-deductible? -- Azim

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Dear Azim,
A mortgage lender will sometimes charge a penalty for the early payoff of a loan. Usually, the penalty is only for an early payoff in the first few years of the loan. The penalty is considered an interest charge and is deductible in the same manner as the underlying mortgage interest. For example, if it's a home mortgage loan on your first or second home, the penalty would be deductible on Schedule A as home-mortgage interest. If the loan is for a rental property, then the interest would be deducted on Schedule E.

Similarly, points that had been deducted over the life of the loan would be deductible in the year that the underlying mortgage is paid off, with one exception: In a refinance, points paid must be deducted over the life of the new loan, while points paid on the purchase of a principal residence can be deducted upfront.

For example, in a refinance, if the new mortgage term is for 30 years and you paid $3,000 in points, you would claim an annual deduction of $100 for the points paid. If you refinance, sell or pay off the mortgage early, you can deduct the remainder of the points in that year. The one exception to the deduction would be if you refinance with the existing lender. In this case you would have to continue to amortize the remaining points over the life of the new loan, together with any points paid on the new refinance.

Bankrate.com's corrections policy
-- Posted: Sept. 15, 2005
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