When taxpayers see “penalty,” the general assumption is the expense is non-deductible.
Oftentimes, when borrowers pre pay all or even a portion of their mortgage balance, their lender contractually obligates them to pay a penalty. Rev. Rul. 57-198 provides that a mortgage prepayment penalty is currently deductible as interest expense in accordance with IRC Section 201(c)(1). In the case of mortgage prepayment penalties, the reasoning is that the prepayment penalty is merely the higher cost of short-term borrowing versus long-term borrowing, therefore making the payment deductible as interest.
Similarly, if a late payment penalty is, in effect, an increased rate of interest, rather than an arbitrary charge not measured by the passage of time, it may be deductible. This deductibility is determined based on the facts and circumstances of each case. Case history has made the determination based on the resemblance that the penalty calculation bears to the interest calculation, the correlation to the passage of time and related to market rates, the consistency of the late charge amount, and the correlation between the charge and the amount of time the payment is late.
In the end, penalty (as it may relate to a mortgage) may not always mean that it is nondeductible.
Please contact your SD representative if you have any questions regarding the deductibility of mortgage prepayment and late penalties.
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