Background

Banks and other financial institutions often charge points when lending money to taxpayers acquiring real estate. Points are a form of prepaid interest and are typically calculated as a percentage of the mortgage amount.

In determining when to deduct points paid in a given year, IRC Sec. 461(g) generally provides that a cash-basis taxpayer must treat prepaid interest in the same manner as that of an accrual-basis taxpayer. In essence, under the general rule of IRC Sec. 461(g), both the cash-basis and accrual-basis taxpayer would be allowed a deduction for the year in which the interest represents a charge for the use or forbearance of money.

IRC Sec. 461(g)(2) provides an exception to the general rule. Under this exception, a cash-basis taxpayer will be allowed to deduct points in the year paid where certain conditions are satisfied. These conditions include the following: 1) the points must be paid on indebtedness secured by the principal residence of the taxpayer; 2) the points must be paid on indebtedness incurred in connection with the purchase or improvement of the principal residence; 3) the payment of points must be an established business practice in the area in which such indebtedness is incurred; and 4) the amount of such payment must not exceed the amount generally charged in such an area.

Rev. Proc. 94-27

Recently issued Rev. Proc. 94-27 provides that, as a matter of administrative practice, the IRS will treat amounts as points that are deductible by a cash-basis taxpayer in the taxable year in which paid. To qualify, all of the following requirements must be satisfied:

1. The Uniform Settlement Statement (Form HUD-1) must clearly designate the amounts as points payable in connection with the loan. These amounts include those designated as "loan-origination fees" (including those so designated on VA and FHA loans), "loan discount," "discount points," or "points";

2. The amounts must be computed as a percentage of the principal amount of the loan;

3. The points must be charged under established business practices;

4. The points must be paid in connection with the acquisition of a principal residence that secures the loan; and

5. The points must be paid directly by the taxpayer. An amount is so paid if the taxpayer provides down payments, escrow deposits, earnest money, and/or other closing funds in an amount at least equal to the total points financed by the mortgage provided that the taxpayer subtracts the amount of any seller-paid points in computing the basis of the residence.

For purposes of the Uniform Settlement Statement requirement, Rev. Proc. 94-27 provides that amounts designated as points on Form HUD-1 may be shown as paid from either the borrower's or the seller's funds at settlement. Moreover, for purposes of the "directly paid" requirement, Rev. Proc. 94-27 provides that points paid by the seller (including points charged to the seller) in connection with the loan to the taxpayer will be treated as paid directly by the taxpayer/buyer.

Transactions Outside the Scope Of Rev. Proc. 94-27

While Rev. Proc 94-27 provides a safe harbor for the immediate deduction of points by a taxpayer satisfying certain conditions, it also contains a listing of transaction outside of its scope. Rev. Proc. 94-27 does not apply to--

1. points paid on loan refinancings, home equity loans, or line of credit loans, even though the debt is secured by the taxpayer's principal residence;

2. points paid in connection with the acquisition of a residence to the extent the points are allocable to amounts that are not treated as acquisition indebtedness; e.g., the mortgage exceeds $1 million;

3. points paid in connection with a loan, the proceeds of which are used to improve rather than to purchase the residence; and

4. points paid in connection with a home other than a principal residence (such as a vacation home).

Effective Date

Rev. Proc. 94-27 is effective for points paid by cash-basis taxpayers during taxable years beginning after December 31, 1990. Cash-basis taxpayers may change their method of accounting for points paid--but not previously deducted on a prior return--by filing Form 1040X. Taxpayers filing an amended return in order to claim seller-paid points should write "Seller-Paid Points" on the top right hand margin of the amended return and should attach a copy of the applicable Form HUD-1 (or other settlement statement) showing the amounts paid by the seller.

A Tax-Planning Opportunity Involving Seller-Paid Points

Rev. Proc. 94-27 may encourage the future use of seller-paid points when selling and financing homes. For example, assume that a taxpayer is considering whether to purchase a principal residence for approximately $240,000, of which $200,000 will be secured by a mortgage. Assume also that the prospective seller agrees to pay four points to the lender (on behalf of the buyer) if 1) the buyer increases his offer from $240,000 to $248,000 and 2) the real estate broker and agent forego their commission on the $8,000 increase in the sales price.

As a result, the net effect to the seller of selling his home for $248,000 and paying $8,000 in points will be approximately the same as selling his home for $240,000. However, the seller-paid points enables the buyer to purchase the house, bring $ 8,000 less cash to the closing and generate an $8,000 Schedule A deduction.

A Major Departure

Although several of its requirements echo the requirements of IRC Sec. 461(g)(2), Rev. Proc. 94-27 is a major departure from prior administrative practice. For the first time, where certain conditions are met, the IRS will allow buyers to deduct seller-paid points.

Bruce M. Bird, JD, CPA, Paul Baker, PhD, CPA, and J. Harrison McCraw, PhD, are associated with West Georgia College.