IRS Issues Ruling on "ARM" Interest Refunds

Taxpayers who claim an itemized deduction for the interest they pay on their adjustable rate mortgages (ARMs) and receive a refund from their mortgage company in a following year will include the refund as income on their tax returns for that year, the IRS said in a revenue ruling today.

The Internal Revenue Service said that the ruling applies to taxpayers who pay ARM interest at a rate that is subsequently determined by the lender to have been too high. In these situations, the lender refunds the overpayment in the form of a payment or by reducing the outstanding principal amount of the loan.

The ruling does not affect people who claimed the standard deduction on their tax return and then receive an ARM interest refund. Because they did not claim a mortgage interest deduction, they will not need to report a refund as income.

The IRS also noted that some taxpayers who are affected will treat only a portion of their ARM interest refunds as income on their tax returns. This will occur where the ARM interest refund is more than the difference between their total itemized deductions and the standard deduction they could have claimed.

For example, a married couple filing a joint tax return was entitled to a $5,700 standard deduction on their 1991 tax return. If they claimed $6,000 in total itemized deductions on the 1991 tax return and received a $500 ARM refund in 1992, then only $300 of the refund would be included on the 1992 tax return. If, however, they claimed $6,200 or more in itemized deductions, all of the $500 refund would be reported as income on their 1992 return.

IRS said the tax treatment of ARM refunds is the same as refunds of state income tax, where taxpayers overpay their state income tax, deduct the amount they actually paid, and then receive a refund of the overpayment in the following year.

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