Loan Points

As I have said on many occasions, tax returns are more a work of creative art than cold calculating science. This is why a dozen different tax preparers can take the exact same data and come up with a dozen different looking tax returns, and all of them can be legally correct. There can be huge differences in the bottom line taxes. Which tax return is the “better” one depends on who you ask. The reason I have never taken part in those contests is because they almost always have someone from the IRS judging the results. Since my objective has always been to come up with the best tax returns for my clients, there is no way IRS would award me any prizes for coming up with the lowest possible tax numbers, when someone else can take the same facts and have a much higher tax.

One of the many areas in which there are variations in how to handle them on a tax return is loan origination costs, usually in the form of points, buy-downs or discounts. With the recently dropping mortgage interest rates, this is once again a timely topic. It was even the subject of Tom Herman’s tax column in the Wall Street Journal this week. Since he didn’t include the more beneficial way to deduct loan points, I felt the need to explain it once again.

Loan origination costs incurred for the purchase of a primary residence are fully deductible in the year the home is purchased. The following discussion deals with other kinds of mortgages.

It has long been a requirement to amortize loan points for residence refi’s and for the purchase of business & rental properties over the life of the loan. Most people assume this to mean the nominal life of the loan, such as the standard 15 or 30 year term of most mortgages.

Since almost nobody keeps a loan for its full term, using 15 or 30 years is not a realistic way to account for this. For at least the past 20 years, I have been amortizing those loan origination costs over the expected life of the loan. I usually ask the clients what their plans are for possible future sales or refi’s. If they don’t have any specific plans, I use the statistical average of five years, because most people will either sell or refi within five years.

What this allows us to do is to deduct one-fifth of the loan costs each year for five years, which works out to be a deduction that is six times as large as someone who amortizes over a 30 year life. For example, if you had paid $3,000 in loan points, the expected life method would give you a deduction of $600 per year for five years, while the nominal life method would allow only $100 per year to be deducted. Since the time value of money generally makes a deduction more beneficial sooner rather than later, this is in the best interest of the clients. If you were to use a 30 year expected life of the loan, you would get tiny deductions in the early years and then a big lump sum in the year the loan is paid off, usually five years out.

Since five years is an estimated life, we obviously have to eventually adjust to reality. If after five years, the clients still have the same loan, we just don’t claim anything in years six and on. What happens most often is that there is a sale or refi before the full five years, and we deduct the remaining un-amortized balance in that year.

I have had this method of amortizing questioned a few times by IRS during audits. Every single time, they agreed with my logic and allowed the expected life to be used. Never once has such a deduction been denied by IRS, and I have prepared thousands of 1040s using that method of amortization.

If you have already started an amortization schedule using 15 or 30 years, you are not stuck with it. While it is not usually enough of a difference to justify filing amended tax returns, you can do that. What I normally do when taking on new clients whose former preparers used the nominal life is to change the amortization period from that point on, as of the first tax return I am working on. Again, IRS has never once had any problems with that.

KMK

Fighting Off New Taxes

Just to the East of us, the lying Governor of Tennessee and his partners in crime have been trying to sneak in a new income tax. Luckily, the message was spread by some talk radio hosts, such as Steve Gill in Nashville and it was defeated, for now.

Congrats go out to the foes of the tax, along with the hope that they never let down their guard. Tax & spend politicians are very patient and very sneaky in pursuit of their goal, to take as much money as possible from their subjects.

KMK

Tax Simplification

A few days ago, IRS announced that they have raised the threshhold for needing to attach Schedule B to 1040 forms. For as long as I can remember, if you had interest or dividend income of more than $400 during the year, you have been required to list the payers on Sch. B. With totals less than $400, you could just enter them directly on your 1040 without any requirement to show the details.

I assure you, I’m not just looking for excuses to disagree with IRS. I have no shortage of those. However, while I applaud their efforts to simplify things for taxpayers, I can’t endorse this new plan, for basically the same reason I don’t advocate electronic filing of tax returns.

IRS has become very efficient at matching up information documents received from payers, such as W-2s and 1099s, with income tax returns, and automatically kicking out notices when too little income is being reported. If too much income is reported, IRS isn’t about to alert you to that.

While it is impossible to completely avoid discrepancies with IRS figures, I have found that a good way to minimize that happening is to attach a lot of details to tax returns, especially when you have something a little out of the ordinary. For example, I frequently attach Sch. B when the total interest or dividends is less than $400 because I want IRS to see how we arrived at our total. This is very important for jointly owned accounts, where we need to back out a portion of interest that is being reported by someone other than the person whose name & SSN are on the 1099. It is also important for nominal accounts, such as minor children, where a parent’s SSN is on the account, but we are backing out the interest on Sch. B.

While some tax preparers do charge a certain amount per schedule or form, my computer program does all of that work; so I have always charged purely based on my time, regardless of how many different pages we have. By including the details of interest & dividend income, even when they are lower than the required amount (now $1,500), there is a very good chance that IRS will be able to match everything up at the Service Center and not need to send you or your client a discrepancy letter and bill.

Again, I have found that there are some tax preparers around the country who have a shortage of work after April 15; so they intentionally avoid attaching too much explanatory documentation to tax returns just to generate some off-season work responding to IRS notices and handling the audits that this causes.

KMK

Breaking Promises

One of the main areas in which I differ from my fellow Libertarians is the issue of term limits. They make the point that we do have terms limits in the form of the ballot box. That would be true if there were anything close to an even playing field in elections. It has long been a job for life once a politician has made it into office. The power of incumbency is next to impossible to beat, which is why 99% of them win each time they run for re-election.

Over the past decade, there have been some politicians who have actually had the nerve to take a voluntary term limit vow. They swear that they will only serve two or three terms and then they will retire. When it comes time to actually honor that pledge, guess what. With very few exceptions, they decide that their vow is no longer relevant, such as this joker in Colorado, Tom Tancredo. Having tasted the awesome power of the throne, there is no way they are going to go back to the real world in which we peasants are forced to reside. They know that, with the vast powers of incumbency, they can easily overpower any resentment over the broken promise.

I sincerely believe that if our founding fathers had known how our elected rulers would refuse to leave, they would have included formal limits to prevent this kind of royalty. That is what the Revolutionary War was all about, being governed by average real world people instead of lifetime royal rulers.

We now have 280 million people in this country. It is such extreme arrogance to believe that there aren’t enough talented people among them to allow a constant supply of fresh faces in the Capitol. To say that the 535 rulers we have in DC are the absolute only ones capable of doing the job of ruling us peasants is no different from any other society governed by an elite few. I have much more faith in the people than do the worshippers of professional lifetime politicians. In fact, I would prefer a lottery to draw names for people to serve a two year term and then move back to the real world than continue being subjects of the career politicians.

A voluntary term limit pledge is as legitimate as a promise by a Clinton (Bill or Hill) not to run for President. What we need is a Constitutional amendment to limit the time any person can sit on the throne.

KMK

Equality

You can be sure that, when you start hearing stories about the income & wealth gap, or the rich getting richer & the poor getting poorer, there will be some push to make everyone equal. This is accomplished in the ideal minds of Communists by redistributing the wealth from the haves to the have-nots. This entire logic is flawed on so many levels as to make me sick.

Equality in a free capitalist society means the equal opportunity for each person to avail him/herself of what the free market offers. It in no way means that everyone’s results will be equal. The people who bemoan the big disparity in wealth conveniently ignore that there are some very good reasons for that inequality. In most cases, it is based on the choices people have made. The best example is with people begrudging the money some doctors earn. The truth is that very few of those envious people have the persistence or strength of character to do what it takes to make it through medical school to become a doctor. Those are sacrifices that most people just wouldn’t do.

Why then is it wrong to reward the ones who do make those sacrifices well for their efforts? Why does some high school drop-out, who sits on his butt all day smoking cigarettes and watching Jerry Springer feel entitled to the same financial rewards as someone who went into hock up to his eye-balls and spent a decade in school? Worse still, why do our rulers feel justified in confiscating what the hard worker has and giving it to the lazy bum?

For an interesting take on making everyone equal, P.J. O’Rourke covered it well in this speech from 1997.

KMK