Finance at time of Purchase?

My new clients were in the process of buying a new condo. Their kids were successfully launched (Yeah!!!) so they were selling their large family home and buying a smaller home consistent with their new lifestyle. They had plenty of equity and were wondering about just paying cash for the home, leaving open the possibility of refinancing it at some later date. That choice turns out to have significant implications.

First, the IRS has specific rules about the deductibility of interest on home mortgage debt. Debt incurred at the time of purchase is called acquisition indebtedness. Interest on that debt up to a limit of $1.1 million can be deducted on Schedule A.

Mortgages taken out after acquisition, however, are deemed to be equity indebtedness. They receive totally different treatment for tax purposes. Deductibility of interest on that type of debt is limited to the interest on $100,000 plus any amount of money that is used to improve the value of the property. For example, if you took out an additional $200,000 on a refinance loan and used $50,000 to re-model the home, theoretically only the interest on $150,000 would be deductible, but no more.

Now I say "theoretically" because, in practice, this rule applies only to those who get audited by the IRS. Absent an audit in the future, you can do anything you want. But prudently, you never know what is going to push the IRS' hot button next. You cannot have missed all the news over the last few years, one I have discussed here also, that the cash from cash-out refinance transactions and equitylines funded the consumer spending that kept our economy ticking along at such a good clip.

As long as the Administration wants this to continue, they may tell the IRS not to be eager about auditing people for potential infractions. However, the next Administration may feel differently, that there are billions of dollars to be collected if they could find people who were getting large deductions by writing off interest on more than the allowed debt.

As a general rule, smaller loan transactions like you and I might do would not likely trigger an audit which would raise the issue. However, I can see someone doing it on a $1,000,000 transaction, being audited, having one giant surprise and a painful, costly issue to deal with.

Another reason to finance at time of purchase also comes to us courtesy of the IRS. It has to do with the deductibility of points paid through escrow. Points are clearly deductible when paid as part of a purchase transaction. However, in the case of a refinance, especially one done in a different tax year than the purchase, the points would have to be amortized over the life of the loan, 30 years in most cases. In our example above, that takes the initial year deduction from a 1 point, $4,000, down to $133. To me, that is an even more compelling reason to fund the loan at time of purchase.

There is another advantage to financing the purchase at the time of acquisition. There is always a lender or two who offer, say, a .25 point discount off the fees for purchase transactions, feeling, correctly I think, that they will be in the servicing portfolio longer. This is good thinking and we are always keeping our ears open for such deals as they represent a $1,000 saving for our client on a $400,000 loan, common for this area.

There is a double whammy here in that on Conforming loans where the loan-to-value, LTV, is greater than 70%, FannieMae and FreddieMac assess a .25 point and sometimes higher bump for cash out transactions. This bump applies to virtually all Jumbo (more than $417,000) cash-out refinances, regardless of LTV. The means there could be as much as a .5 point difference, $2,000 on a that $400,000 loan. In addition, the owner would have to pay the title and escrow fees again, say another $1,500, duplicating the expenses on the purchase.

For those reasons, I can see absolutely no justification for not financing the home at the time of purchase and 3,500 reasons NOT to do it later.

I recognize that each family's situation is different, and you ought to get advice from experts. I'll stand by my analysis as an expert in the mortgage market, but consult your tax advisor for advice on tax conseqences.