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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

Mortgage points, fees and the IRS -- what's deductible and when

Dear Dollar Diva,
My wife and I are first time home buyers and have the following questions: What is the difference between an origination fee and points? Are they deductible? If so, are they deducted in the year paid or over the life of the loan?

Dear Ridgely,
Congratulations on your new home. Life gets more complicated when you're a homeowner, but those complications can deliver some nifty tax deductions. Here's the lowdown on the deductibility of origination fees and points.

Origination fees
A loan origination fee is levied by a lender for underwriting a loan. The fee often is expressed in points. A point is 1 percent of the loan amount. Your origination fee is deductible as long as it was used to obtain a mortgage and not paid in lieu of other fees, such as attorney or appraisal fees. The IRS specifically states that if the fee is for items that would normally be itemized on a settlement statement, such as notary fees, preparation costs, and inspection fees, it is not deductible. The IRS notes other requirements in Publication 530.

Points come in two flavors:

1. Prepaid interest: the more you pay upfront, the lower your interest rate.
2. Origination fee: Described above

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In general, the deduction of points depends on the purpose of the loan: to acquire or improve your home, or refinance an existing mortgage.

In your case, the points were to acquire your main home; therefore all of the points should be deductible this year. If, in the future, you pay points to refinance your home, the points will get deducted over the life of your loan. If you pay $3,000 in points on a 30-year loan, you will get to deduct a paltry $100 per year.

However, if you get a second mortgage to improve your home, such as to add a deck or an upstairs bedroom, the points should be fully deductible in the year paid.

It's important to know that points paid on a main home only are fully deductible the year they were paid. A main home is the one you live in most of the time, and you can only have one. If you pay points to buy a second home and only live there in the summer, those points will get deducted over the life of the loan.

IRS Publication 530
IRS Publication 530, Tax Information for First-Time Homeowners, is a good primer for new homeowners. The Diva gave you the broad strokes on the deductibility of origination fees and points, and Publication 530 is where you'll go for the nitty-gritty.

There's a helpful flowchart in the publication called "Are my points fully deductible this year?" Most of the questions it asks are no-brainers, but there are two that might have you scratching your head. They're explained in the publication, but the Diva thought you might appreciate a head's up:

1. When it asks if you use the "cash method of accounting," answer yes unless you know otherwise, and move on to the next question. FYI, the other method is called "accrual" -- it's rare and you know it if you use it.
2. When it asks "were the funds you provided ... plus any points the seller paid, at least as much as the points charged?" don't freak out. The answer is probably "yes" but the IRS is bent on making you crazy before it lets you say it.

An asterisk on the flowchart explains: "The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose." The Diva explains below, in plain English:

If you paid $3,000 for points from money you had in savings or you borrowed it (from anyone except your mortgage lender or broker), answer yes, and move on to the next question.

If you borrowed from your mortgage lender or broker, you're still in the running. Add up what you paid out of pocket at closing for any purpose, including the down payment, escrow deposit and earnest money, plus any points the seller paid on your behalf. If the total is at least $3,000, you get to deduct the whole $3,000 this year. If it's only $2,500, you get to deduct $2,500 this year, and the remaining $500 gets deducted over the life of the loan.

Most folks make a down payment and escrow deposit when they buy a home. The cost of those two items, alone, is almost always more than the cost of the points, so in the vast majority of cases the answer to the question is yes.

The Diva thinks that this officious complexity is insulting to taxpayers. The purpose of the full deduction is supposed to be to give a tax break to new homeowners, not lifetime employment to tax professionals. But she doesn't write the tax laws; she only complains about them.

-- Updated: June 14, 2006

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See Also
When do you pay points?
Don't overlook the tax breaks of home mortgage points
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