A point on a mortgage loan is one percentage point of the loan. For example, two points on a $200,000 mortgage loan would be $4,000 ($200,000 x 2%). Points represent prepaid interest.

A taxpayer who uses the cash method of accounting may deduct points paid on a loan to buy or improve a principal residence as long as the points are a normal business practice in the area, are reasonable in amount, and the loan is secured by the residence (Sections 163(h)(3)(B) and 461(g)(2)). Interest, including points, on a loan to acquire or improve the taxpayer's residence is limited to the interest on the first $1,000,000 of the mortgage loan.

The limit on deductibility of interest on a loan to acquire a residence applies to the taxpayer's principal residence and one other residence (Section 163(h)(4)(A). However, a taxpayer may deduct points paid in the year paid only in connection with a mortgage loan on the taxpayer's primary residence (Section 461(g)(2)). If a taxpayer pays points on a mortgage loan to purchase a second home, the taxpayer must amortize the points over the life of the loan.

A taxpayer claims the deduction on Schedule A of Form 1040. A buyer may deduct the points even if the seller pays them (Rev. Proc. 94-27, 1994-1 CB 613). A taxpayer who uses the accrual basis of accounting must amortize the points over the life of the loan.

If a taxpayer pays points on a home equity loan, the taxpayer may not deduct the points immediately unless the taxpayer uses the proceeds of the home equity loan to improve the property. If the taxpayer does not use the proceeds of a home equity loan to improve the property, the taxpayer must amortize the points over the life of the loan (Sections 163(h)(3)(C) and 461(g)(1)).

The deduction of interest, including points, on a home equity loan is limited to the interest on a home equity loan up to $100,000 unless the taxpayer uses the home equity loan for business purposes. If the taxpayer pays the loan off early, the taxpayer may deduct the unamortized points in the year paid (Temp. Regs. Sec. 1.163-10T(j)(3)).

The same rule that applies to a home equity loan also generally applies to a refinancing of a taxpayer's mortgage loan. The taxpayer may not deduct the points immediately. The taxpayer must amortize the points over the life of the loan. If the taxpayer pays the loan off early, the taxpayer may deduct the unamortized points in the year paid.

However, for taxpayers who live under the jurisdiction of the U. S. Court of Appeals for the Eighth Circuit, if the taxpayer pays points on a mortgage loan and uses the proceeds to pay off a short-term bridge loan, the taxpayer may deduct the points in the year paid (Huntsman v. Commissioner, 90-2 USTC Para. 50,340, CA-8, 1990, rev'g 91 TC 917). The U. S. Court of Appeals for the Eighth Circuit has jurisdiction over taxpayers in the states of Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota.

If a taxpayer pays points on a mortgage loan to acquire undeveloped land, a commercial building, or rental real estate, the taxpayer must amortize the points over the life of the loan. If the taxpayer pays the loan off early, including a sale of the property, the taxpayer may deduct the unamortized points in the year paid.

Taxpayers should remember to deduct points paid in connection with a mortgage loan to purchase or improve their principal residence, whether the purchaser or seller pays the points. For points paid in connection with a refinancing of a mortgage, to obtain a home equity loan, or to obtain a mortgage loan on rental or commercial property, taxpayers should remember to deduct the points over the life of the loan and deduct the unamortized points in the year the taxpayer pays the loan.

Alan D. Campbell is a CPA in Arkansas and Florida and is self-employed primarily as an author of tax publications. He earned a Ph.D. in accounting with an emphasis in taxation from the University of North Texas. He is also admitted to practice before the United States Tax Court. He has published numerous articles on tax topics in professional journals. He is the co-author of the book Tax Strategies for the Self-Employed and the revision editor of CCH Financial and Estate Planning Guide, 15th edition. For more tax savings strategies, please see his blog: http://taxsavingsstrategies.blogspot.com