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I refinanced my principal home last year and paid points. What are points, and can I deduct them on my tax return?

Points are costs that a lender charges when you take a loan on your home. One point equals 1 percent of the loan amount borrowed. If the points are charged for services that the lender provided in preparing or processing the loan, they are not deductible. However, if the lender charges the points as up-front interest and in return gives you a lower interest rate on your loan, the points may be deductible. It doesn't matter whether your lender calls the charge "points" or an "origination fee." If the charge represents up-front interest, it may be deductible.

Points paid on a refinanced loan in a given year cannot simply be deducted outright on your tax return. Instead, they must be amortized over the life of the loan. However, there is one exception. If part of the loan is used to make improvements to your primary residence, you can deduct that portion of the points allocable to the home improvements made.

For example, you take a cash-out refinance mortgage for $100,000 and pay two points ($2,000) as prepaid interest. Assume $90,000 is used to pay off the principal debt owed on the old mortgage, $4,000 is used to pay off bills, and $6,000 is used to put in a new kitchen. Since 6 percent ($100,000 divided by $6,000) is used for home improvements, $120 (6 percent of $2,000) may be deducted in the year the loan is taken. The remaining $1,880 in points must be deducted pro rata over the life of the loan.

Different rules apply if points were paid on a loan used to buy your primary residence, rather than to refinance it.