The tax law allows a deduction for mortgage interest on a qualified primary residence and one vacation home. Specifically, to be deductible, the purpose of the mortgage must be for acquisition or improvement.
A careful reading of the law reflects that points charged by a bank upon the refinancing of a mortgage also are deductible as interest expense.
However, the law does not specify whether refinancing points are fully deductible in the year paid or if they must be prorated over the life of the new mortgage. The IRS has taken the position that refinancing points must be prorated over the life of the new mortgage.
In a recent case, the IRS interpretation of the law has been challenged. In Huntsman vs. Commissioner, the 8th Circuit Court of Appeals reversed a 1988 Tax Court decision and held that points paid to refinance a short-term mortgage with a permanent mortgage are fully deductible in the year paid.
The Huntsmans acquired a residence in 1981, a period of high interest rates. Hoping for a decline in rates, the Huntsmans took out a three-year mortgage. The next year, the Huntsmans took out a second-mortgage home improvement loan, and shortly before the end of the third year, they refinanced both mortgages with a 30-year mortgage and paid $4,400 in points.
The taxpayers deducted the points on their 1983 tax return. The IRS disallowed the deduction.
The Tax Court supported the IRS position. The Huntsmans appealed. The appeals court held that when a buyer purchases a home with short-term financing, and then refinances the loan with permanent financing, the permanent mortgage should be treated as if it had been incurred with the original purchase.