Prepaid Finance Charges: Understanding Tax Deductibility

Prepaid finance charges, often referred to as points, are fees paid upfront to a lender to reduce the interest rate on a loan. They’re most commonly associated with mortgages but can also occur with other types of loans.

Mortgage Points: Deductible, But with Conditions

The good news is that mortgage points are generally tax-deductible in the year they’re paid. However, several requirements must be met. The IRS outlines specific criteria to ensure the points are legitimate and qualify for a deduction:

• The Loan’s Purpose: The loan must be used to buy, build, or substantially improve your main home. Refinancing situations also apply, but the rules differ (explained below).
• Payment as a Business Practice: Paying points must be an established business practice in your area, and the amount paid should be reasonable for the loan amount.
• Funds Provided by You: You must provide the funds used to pay the points. You can’t finance the points through the loan itself. While seller-paid points are no longer deductible by the buyer, some specific arrangements may allow the buyer to deduct them. Consult a tax professional.
• Calculation Based on Loan Amount: The points must be calculated as a percentage of the loan amount.
• Clearly Designated: The points must be clearly designated as points on your settlement statement (e.g., Form HUD-1 or Closing Disclosure).

Refinancing and Points: A Different Deduction Approach

If you paid points when refinancing a mortgage, you can’t deduct the full amount in the year you paid them. Instead, you deduct them proportionally over the life of the new loan. For instance, if you paid $3,000 in points on a 30-year mortgage, you’d deduct $100 each year ($3,000 / 30 years). If you sell the property before the loan is paid off, you can deduct the remaining unamortized points in the year of the sale.

Other Loan Types and Finance Charges

While mortgage points are the most common deductible prepaid finance charge, some other finance charges associated with other types of loans might also be deductible, albeit less frequently. This generally applies to business loans where the interest expense is deductible. Consult a tax professional to determine if any prepaid finance charges on a business loan qualify for a deduction.

Keep Good Records

Regardless of the type of loan, maintaining thorough records is crucial. Keep your settlement statement (Form HUD-1 or Closing Disclosure) and any other documents related to the loan origination. These documents are essential when filing your taxes and will be helpful if the IRS ever questions your deduction.

Consult a Tax Professional

Tax laws can be complex, and individual situations vary. It’s always recommended to consult with a qualified tax professional to determine the specific deductibility of prepaid finance charges in your specific circumstances. They can provide personalized advice and ensure you’re taking all eligible deductions.