Tax quirk could make your home more attractive to buyers

House made of coins

If you're selling a home, here's how to make it more attractive to potential buyers: Throw in some cash and an income tax deduction.

The Internal Revenue Service allows the seller to pay points -- that's a fee some homeowners pay to lower their mortgage rates -- on the buyer’s behalf. Then the buyer gets to deduct the points as mortgage interest.

Depending on the home buyer's marginal tax rate, a deduction of $2,000 in seller-paid points could result in $500 in free money.

The IRS considers points to be prepaid mortgage interest, and mortgage interest is tax-deductible for many taxpayers.

To take full advantage of the mortgage interest tax deduction, taxpayers must itemize their deductions and have less than $1 million in mortgage debt.

Usually, home buyers can fully deduct points in the year they pay them if the relevant mortgage is for a primary residence and if buyers don’t borrow money to pay points from a lender or mortgage broker.

Later on, when the buyer sells the home, the seller-paid points must be subtracted from the home’s cost. The buyer could thus end up paying more in capital gains tax down the road.

The present deduction is a sure thing, however, while the capital gains tax may never apply.

If this seems like a raw deal for the seller, it isn’t necessarily.

While the seller doesn’t get to deduct the points as mortgage interest, the IRS does consider the points a selling expense that reduces the amount of gain the seller realizes from the sale. If the seller is facing possible capital gains tax on the sale of the home, reducing the gain will reduce tax liability.

It might seem improbable that anyone would be in danger of exceeding the $250,000 capital gains tax exemption ($500,000 for married couples) in this housing market, but homeowners who have been in the market for many years may indeed be in that situation.

If the seller were in the 25% tax bracket and had held the home for more than a year, his capital gains tax rate would be 15% in 2011. The points he paid on the seller’s behalf would actually only cost him 85% of $2,000, or $1,700.

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