Question:

Are prepayment penalties tax deductible?

Answer:

Mortgage prepayment penalties are fully tax deductible if the mortgage is fully paid. If a mortgage is refinanced then also it can be tax deductible but only in the case if it is not rolled into the new loan amount.

Confirmation from the IRS

According to the IRS, prepayment penalties are deductible from the federal income taxes as long as the penalty is not a fee for a service rendered by the lender. As prepayment penalties are not service fees but rather a penalty for paying off the loan too soon, you can deduct from your taxes. However, to be absolutely sure, talk to a professional tax advisor and visit the IRS website.

When is a prepayment penalty tax deductible?

For the prepayment penalty to be tax deductible it must be paid i.e. a transaction must occur that shifts payment from the borrower's account to the lenders. Prepayment penalties that are rolled into another loan through refinancing simply become part of that loan and then do not remain tax deductible.

How to claim tax deductibility?

The first thing you need to do to claim tax deduction on mortgage interest is that you need to itemize your deductions on your Schedule A. If you have rental property and you want to claim interest deduction on that, you report mortgage interest on your Schedule E. One minor point:  ensure your itemized deductions exceed the standard deduction offered by the IRS before filing your taxes.

Last Word

While the IRS rules are fairly clear on their website, it's always prudent to speak with a licensed CPA or tax advisor before you formally claim any large deductions on your taxes. As mortgage lenders have different variations of prepayment penalties, talking to a professional can help you with your individual case and perhaps even find a bigger deduction than you thought.

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