To be deductible, points paid by the buyer must first be determined to be interest, rather than a payment for services. Under case law, points are interest if they:
• are calculated in a way similar to the way stated interest is calculated;
• are considered by the lender to be part of the debt's interest yield;
• are not paid if the loan does not close; and
• are not related to the lender's costs of making the loan. [Pacific First Federal Savings & Loan Ass'n v. Comr., 79 T.C. 512 (1982). )]
For closings that occur after 1990, the IRS has stated that only points that meet all of the following criteria are mortgage interest:
• the amounts are charged for the use or forbearance of money and not for services;
• the amounts conform to an established business practice of charging points in the area in which the loan was issued and do not exceed the amount generally charged in the area;
• the amounts are for mortgage loan proceeds provided for and applied to closings occurring after Dec. 31, 1990; and
• the amounts are paid directly by the buyer. [Notice 90-70, 1990-2 C.B. 351. This Notice specifically provides guidance concerning mortgage interest for purposes of §6050H reporting requirements. However, it also suggests a modified standard for the deductibility of points. ]
An amount is considered "paid directly by the buyer" if the buyer provides funds (including down payments, escrow deposits, earnest money applied at the closing and funds actually paid over a closing) at least equal to the amount of points required for application at the closing. In addition, in view of standard commercial lending practices, an amount charged to the buyer as points with respect to the acquisition of a principal residence is treated as paid directly by the buyer.
Historically, borrowers were advised to pay points with a separate check at closing to ensure their deductibility. However, the IRS no longer requires taxpayers to pay points by separate check, so long as the points are in fact "paid directly by the mortgagor." Specifically, points are considered paid directly by the mortgagor "if the mortgagor provides funds (including down payments, escrow deposits, earnest money applied at the closing and funds actually paid over at closing) at least equal to the amount of points required for application at the closing." [Notice 90-70, 1990-2 C.B. 351.]
Finally, seller-paid points will be treated as paid directly by the buyer if all of the requirements listed below are met. [See Rev. Proc. 94-27, 1994-1 C.B. 613.]
In order to minimize possible disputes regarding the deductibility of points paid in connection with the acquisition a principal residence, effective for taxable years beginning after 1990, the IRS treats amounts paid by cash basis taxpayers as deductible "points" for the taxable year in which they are paid if all of the following requirements are met: [Rev. Proc. 94-27, 1994-1 C.B. 613, superseding Rev. Proc. 92-12, 1992-1 C.B. 663, as modified by Rev. Proc. 92-12A, 1992-1 C.B. 664.]
• Designated on Form HUD-1. The Form HUD-1 clearly designates the amounts as points incurred in connection with the indebtedness. Examples of such designation include "loan origination fees," "loan discount," "discount points," or "points." [The reference to loan origination fees includes amounts designated as such on VA and FHA loans. See Rev. Proc. 94-27, 1994-1 C.B. 613, superseding Rev. Proc. 92-12, 1992-1 C.B. 663, as modified by Rev. Proc. 92-12A, 1992-1 C.B. 664.]
• Computed As Percentage of Amount Borrowed. The amounts must be computed as a percentage of the stated principal amount of the indebtedness incurred by the taxpayer.
• Charged Under Established Business Practice. The amounts paid must conform to an established business practice of charging points for loans for the acquisition of personal residences in the area in which the residence is located, and the amount of points paid must not exceed the amount generally charged in that area. However, amounts designated as points that are paid in lieu of amounts that are ordinarily stated separately on the settlement statement (e.g., appraisal fees, inspection fees, title fees, attorney fees, property taxes, and mortgage insurance premiums), are not deductible as points.
• Paid for Acquisition of Principal Residence. The amounts must be paid in connection with the acquisition of the taxpayer's principal residence, and the loan must be secured by that residence. Examples of points that do not meet this requirement include: points paid in connection with the acquisition of a principal residence to the extent that the points are allocable to an amount of principal in excess of the aggregate amount that may be treated as acquisition indebtedness; points paid for loans whereby the proceeds of such loans are used for improvement of a principal residence, as opposed to the acquisition of a principal residence; points paid for loans to purchase or improve a residence that is not the taxpayer's principal residence, such as a second home or vacation property; and points paid to refinance a loan, a home equity loan, or a line of credit, even though the indebtedness is secured by the principal residence.
• Paid Directly by Taxpayer. The amounts must be paid directly by the taxpayer. An amount is so paid if the taxpayer provides, from funds that have not been borrowed for this purpose as part of the overall transaction, an amount at least equal to the amount required to be applied as points at the closing. The amount provided may include down payments, escrow deposits, earnest money applied at the closing, and other funds actually paid over at closing. In addition, points paid by the seller (including points charged to the seller) in connection with the loan to the taxpayer will be treated as paid directly by the taxpayer from funds that have not been borrowed for this purpose, provided the taxpayer subtracts the amount of any seller-paid points from the purchase price of the residence in computing the basis of the residence. [Rev. Proc. 94-27, 1994-1 C.B. 613, superseding Rev. Proc. 92-12, as modified by Rev. Proc. 92-12A,1992-1 C.B. 664.]
To place cash basis and accrual basis taxpayers on an equal footing, a cash basis taxpayer's interest deduction for interest paid up front as points is limited to the amount of interest that has accrued during the taxable year under economic accrual principles, which means that the points must be deducted over the life of the loan rather than in the year in which they are paid. [§461(g). See also §461(h)] However, this limitation does not apply to points paid on any debt incurred to purchase or improve the taxpayer's principal residence, where:
• the debt is secured by the residence; and
• the payment of points is an established business practice and does not exceed the amount usually charged. [§461(g)(2). ]
Points paid to refinance the loan on a taxpayer's principal residence do not qualify for this exception. However, if a principal residence is purchased with short-term financing, and that loan is replaced with permanent financing, the permanent loan is sufficiently "in connection with" the purchase of the home to fall within §461(g)(2). Huntsman v. Comr., 90-2 USTC ¶50,340 (8th Cir. 1990), rev'g 91 T.C. 917 (1988). In AOD 1991-02, the IRS recommended that certiorari not be sought in Huntsman, but noted, however, its intention to follow this holding only in the Eighth Circuit.
Note: The IRS issued final regulations affecting the reporting of points paid on residential mortgages, effective for taxpayers who, in the course of a trade or business, receive $600 or more of interest, including points, for transactions occurring after December 31, 1994. [Regs. §1.6050H-1(f), T.D. 8571 (59 Fed. Reg. 63248 (12/8/94)).]
The final regulations essentially retain the requirements described above, and provide additional guidance relating to situations where amounts are paid directly by the payor.
Under the regulations, an amount is considered paid directly by the payor of record if it is:
• Provided by the payor of record from funds that have not been borrowed as part of the overall transaction. The amount provided may include amounts designated as down payments, escrow deposits, earnest money applied at closing, and other funds actually paid over by the payor of record at or before the time of closing; [Regs. §1.6050H-1(f)(3)(i)(A).] Unlike the rules discussed above, the regulations do not require the mortgagor to provide funds at least equal to the amount of points paid at closing. - or
• Paid as points on behalf of the payor of record by the seller. For this purpose, the regulations provide that an amount paid as points directly by the seller to the lender on behalf of the buyer is treated as being paid to the buyer and then paid directly by the buyer to the lender. [Regs. §1.6050H-1(f)(3)(i)(B).]
Example (1)—Financed Payment of Points
Buyer purchases a principal residence for $100,000, and total closing costs of $7,000 (excluding the down payment). Of this amount, Buyer is charged $3,000 as points. At closing Buyer makes a down payment of $20,000 and provides unborrowed funds of $4,000 for payment of closing costs other than points. Buyer then finances the payment of the points by increasing the principal amount of the loan by $3,000. The Seller makes no payments on Buyer's behalf. Because Buyer has provided funds that have not been borrowed from the lender for this purpose in an amount at least equal to the amount charged as points, the lender must report the $3,000 as points. [Regs. §1.6050H-1(f)(3)(ii), Ex. 1.]
Example (2)—Seller-Paid Points
The facts are the same as in Example (1), above, except that at the closing, Buyer provides only $20,000 in unborrowed funds as a down payment. In addition, Seller agrees to pay all closing costs on behalf of Buyer, including points. The amount paid by the Seller as points is nevertheless treated as paid directly by Buyer, and the lender must report the $3,000 as points. [Regs. §1.6050H-1(f)(3)(ii), Ex. 2.]
Under the regulations, amounts received directly or indirectly by a mortgage broker are treated as points to the same extent as if they were paid to and retained by the lender of record. [Regs. §1.6050H-1(f)(5).]
In the case of amounts paid in connection with debt incurred to construct a residence, or to refinance debt incurred to construct a residence, the regulations provide that such amounts are deemed to be points to the extent such amounts meet the following requirements:
• The amounts are clearly designated in the loan documents as points incurred in connection with the indebtedness (i.e., as "loan origination fees," "loan discount," "discount points," or "points").
• The amount is computed as a percentage of the stated principal amount of the indebtedness incurred by the payor of record;
• The amount paid conforms to an established practice of charging points in the area in which the loan is issued and does not exceed the amount generally charged in the area;
• The amount is paid in connection with the indebtedness incurred by the payor of record to construct (or to refinance construction of) a principal residence that will be used as the principal residence when completed;
• The amount is paid directly by the buyer; and
• The amount is not allocable to indebtedness in excess of the aggregate amount that may be treated as acquisition indebtedness. [Regs. §1.6050H-1(f)(4)(i). Amounts paid in connection with refinancing indebtedness are not treated as points to the extent that the amounts are allocable to debt that exceeds the debt incurred to construct the residence. Regs. §1.6050H-1(f)(4)(ii).]
Points that fulfill these conditions are deductible by cash basis taxpayers in full in the year in which they are paid.
Even though points are characterized as interest, their deduction may be limited or disallowed by the rules regarding the deductibility of home mortgage interest, for tax years beginning after 1986.
b. Loan Processing and Loan Origination Fees
Loan processing fees and loan origination fees are similar to points in that such fees are treated as interest if they are compensation for the use or forbearance of money, are ascertainable in amount, and are not payment for specific services performed by the lender in connection with the borrower's account. [Rev. Rul. 69-188, 1969-1 C.B. 54; Rev. Rul. 69-290, 1969-1 C.B. 55 (Premium charge was deductible where lender was separately paid for all services performed on the loan).]
Example—Loan Processing Fee
L, a cash basis taxpayer, obtains a conventional mortgage from D & S Bank in order to finance the purchase of a building. In addition to the annual interest rate, D & S requires that L pay a loan processing fee of 7% of the amount borrowed before L receives the loan proceeds. The mortgage loan agreement provides for separate charges for D & S's costs of processing the loan. D & S determines the amount of its loan processing fees by considering the interest rate charged, the security for the loan, and the financial condition of the borrower. This loan processing fee is deductible as interest.
A fee that is imposed in lieu of separate charges for specific loan processing items (e.g., appraisal, deed preparation, notary fees, credit reports), or that is made to defray the expense of such items, is not treated as interest. [Goodwin v. Comr., 75 T.C. 424 (1980), aff'd, 691 F.2d 490 (9th Cir. 1982); Rev. Rul. 67-297, 1967-2 C.B. 87.]
Example—VA Loan Origination
V obtains a home mortgage loan guaranteed by the Veterans' Administration (VA) to purchase a home. V pays the lender a loan origination fee in connection with the loan equal to 1% of the amount borrowed. This fee is charged in addition to the interest rate charged by the lender, which is set at the maximum interest rate allowed to be charged on VA-insured loans. The VA allows lenders to charge up to 1% of the amount borrowed in lieu of certain charges, including appraisal fees, document preparation expenses, and notary fees. This loan origination fee is deductible by V as interest. [See Rev. Proc. 94-27, 1994-15 I.R.B. 17. Amounts designated as "loan origination fees" on VA and FHA loans that are paid during taxable years beginning after 1990 are deductible by cash basis taxpayers as "points" if all the requirements of Rev. Proc. 94-27 are met.]
Where a lump sum fee is imposed, in lieu of separate charges for interest, commissions, and services, but is based on the principal amount of the loan, the courts look to the parties' arm's length agreement to determine what portion of the lump sum fee is interest (as long as the parties' agreement is reasonable). [Rev. Rul. 69-189, 1969-1 C.B. 55.]