Tax Guru – Ker$tetter Letter

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Archive for September 29th, 2002

Posted by taxguru on September 29, 2002

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.


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