These point deductibility rules apply to loan costs associated with your primary residence. When the loan is tied to a property that is not your main home, the points cannot be fully deducted in the year the loan was made. Points paid on a loan secured by a second home or vacation residence, regardless of how the cash is used, must be amortized over the life of the loan.

Refi points

In most refinancing cases, a homeowner must deduct any loan points over the life of the loan. But if part of the refinanced mortgage proceeds are used to improve the main home and tests 1 through 6 listed previously are met, the portion of points attributable to the improvement can be deducted in the year paid. Any points related to the refinanced existing balance, however, are not eligible for immediate tax-deduction purposes; they still must be amortized over the life of the refinanced loan. These points-deductibility rules also apply to home equity loans or home equity lines of credit.

If, however, you use your refi to get some extra cash or take out a home equity loan or line of credit and then use the money for something else, such as paying college costs or buying a car, you still can deduct the points, but not all at once. The points deductions must be parceled out over the equity loan's term.

To figure the annual deduction amount, divide the total points paid by the number of payments to be made over the life of the loan. You should be able to get this information from your lender. For example, a homeowner who paid $1,500 in points on a 30-year second mortgage (360 monthly payments) could deduct $4.17 per payment, or a total of $50 for 12 payments, for each tax year of the loan.

Challenging the amortization rule

In this case, Gary and Rebecca Hurley paid $4,400 in points to refinance their home in 1999. The home equity funds eventually were used to make substantial home improvements. The upgrades took several years to complete, but when the Hurleys filed their 1999 return, they deducted the total points since they knew they were going to use the loan funds toward improving their residence, as the rules state.

The IRS disagreed and instructed the couple to spread the deduction over the life of the 15-year equity loan. The IRS' contention: Since all the loan money was not used in the 1999 tax year for the improvements (it took the couple until 2003 to complete the house work), the immediate deduction was not allowed.

The Hurleys went to tax court. In September 2006, the court agreed with the couple. Specifically, the judge concurred that the refinancing was done, as required by tax law, "in connection with" home improvements, therefore entitling the Hurleys to deduct all of their points in the year they got the loan.

The judge also said the IRS offered no evidence that current rules require the eligible home improvements be done in the year of the refinancing.