Points

As a general rule you can't deduct prepaid home mortgage interest ahead of the year to which it relates. The most common form of prepaid interest is "points."

A point is a charge paid by the borrower to the lender upon taking out the loan. One point equals one percent of the amount borrowed; thus, on a $100,000 loan, three points equals $3,000, but on a $250,000 loan, three points equals $7,500.

Under the general rule, you could deduct points as mortgage interest but you'd have to spread your deduction for points out over the entire life of the loan, even though you actually paid the amount in the first year.

Fortunately, there is an exception that allows many borrowers to deduct their points in the year paid.

You may deduct points in the year you pay them if all of the following are true:

• The loan is used to buy, build, or improve your principal home, and the loan is secured by the home. Thus, second mortgages or home equity loans qualify if the proceeds are used for home improvement - but not otherwise.
• The payment of points is an established business practice in your area.
• The points paid don't exceed the number of points generally charged in the area. If lenders in your area generally charge three points and you pay four, you can deduct the first three in the first year. The fourth point must be deducted over the entire term of the loan.
• The points aren't paid in place of amounts that are usually separate charges, such as appraisal, inspection, title, or attorney fees
• The points are computed as a percentage of the principal amount of the mortgage and are clearly shown on the settlement statement (e.g., Uniform Settlement Statement, Form HUD-1) as points charged for the mortgage.
• If the loan is used to buy your main home, you must have provided funds at the time of closing that are at least equal to the points charged, outside of the money obtained from the lender. For this purpose, the funds you provided don't have to be applied specifically as payment of points; they can be applied to your down payment, earnest money, or other funds actually paid over at closing.
• You must use the cash method of accounting, which is the way most people keep track of their income and expenses (i.e., reporting income and expenses in the year they are received and paid, respectively).

The deduction for points applies only to buyers, and not to sellers, of homes. If the seller pays some points to enable the buyer to get a loan, the buyer may deduct the points. The seller treats the amount paid as a selling cost that helps to reduce his or her taxable profits on the sale.

Second homes. The rules above apply only to your main home. If you pay points on a loan secured by a second home, those points can only be deducted over the entire term of the loan.

Refinancing. Points paid in refinancing a mortgage on your main home are generally not deductible in the year paid. They must be prorated and deducted over the entire loan period.

However, if the proceeds of your refinancing are used both to pay off the old mortgage and to pay for home improvements, the portion of the points that pertain to the home improvements can be deducted in the first year. The remaining portion must be prorated over the loan's entire term.

Paying off your mortgage early. If your mortgage is paid off early (perhaps because you sell the home, refinance to get a lower interest rate, or make enough extra principal payments to retire the loan), at that time you can deduct any portion of points on the old loan that have not yet been deducted.

Example Sharon Flint refinanced her mortgage in 2008 to get a lower interest rate. At that time, she paid $3,000 in points that were required to be spread over the 15-year term of her new loan. Through 2012, she had deducted $1,000 of the points. In 2013, Sharon paid off her mortgage in full. She can then deduct the remaining $2,000 of points in 2013.