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The Rules Around Deducting Closing Costs on Rental Property

by Jeff Rohde, posted in Investment Strategy

If you recently purchased a rental property, you may be wondering what closing costs you can deduct. After all, even though the Internal Revenue Code is extremely friendly to real estate investors, there’s no reason to pay more in tax than you should.

In one way or another, all closing costs on a rental property are deductible, but they are expensed in different ways. Some costs you can write off right away, while other expenses you have to deduct over time.

Here’s a look at how closing costs on rental property work, along with some tips that can reduce or even eliminate the tax you pay on rental property income.

 

What Are Closing Costs?

Closing costs on a rental property are the fees and expenses paid to close escrow, above and beyond the down payment you make for the home. 

These costs generally run between 2% – 5% of the loan amount and are similar to the fees you would pay for an owner-occupied home. However, most title companies offer a discount for real estate investors, so the actual closing fees you pay as a rental property buyer may be a little lower than what the average homeowner would pay. 

The financial technology company SmartAsset has put together a Closing Costs Calculator to help understand the total closing costs and the amount needed at settlement based on the property location, home price, and down payment.

The types of closing costs to expect when you buy a rental property include:

  • Inspection fees for a property appraisal, home inspection, termite and pest inspection, and in some areas a survey and septic inspection, if the property is located in a rural area.
  • Professional fees paid to an attorney or financial advisor to assist you with drawing up and reviewing the closing documents.
  • Mortgage fees such as loan application, credit report, origination, and underwriting fees.
  • Prepaid and impound amounts for property taxes, mortgage interest, homeowners insurance, and HOA fees.
  • Title company fees include escrow fees, recording fees, transfer taxes, and title search.
  • Real estate investors who make a down payment of less than 20% will also be charged a mortgage insurance premium (MIP) with some FHA or VA home loans.

 

Deductible Closing Costs on Rental Property

Closing costs on a rental property are often accounted for in two different ways. Some costs to buy a home can be completely expensed right away, while others have to be added to the property basis and depreciated over time. 

Let’s begin by discussing the deductible closing costs on a rental property that can be deducted right away. According to the IRS, there are only three closing costs that can be deducted in the same year the property is purchased:

Mortgage Interest

As a rental property investor, you can deduct the interest part of your mortgage payment but not the principal payments, because those are used to reduce the mortgage loan liability on the property balance sheet. 

Each year your lender will issue a Form 1098 to report the interest paid on the loan throughout the year.

Mortgage Points

A mortgage point, also known as a discount point, is paid directly to the lender in exchange for a lower interest rate. Each mortgage point equals about 1% of the loan value and covers expenses such as borrower verification services, document preparation and review, and credit check and related fees. 

Not all of the mortgage point expenses are deductible right away. Instead, some portion of the total mortgage point cost will need to be added to your property basis and deducted over the term of the loan. Form 1098 that you receive from your lender will break down the amount that can be expensed right away and those that must be deducted over time.

Deductible Real Estate Taxes

Real estate property taxes are the third deductible closing cost on a rental property. 

Real estate taxes are prorated from the day you purchase the property through the end of the year and are deducted in full for each year that you own the property. For example, if property taxes are $2,700 for the year and you close escrow on June 1st, you would be entitled to deduct the remaining seven months of property taxes.

In some cases, you may close on a property where the seller has already paid the property taxes for the entire year. When that occurs, on the closing settlement statement you will receive a debit or charge to credit the seller for real estate taxes she paid when you actually own the property. 

That prorated share of real estate property taxes can still be deducted as a closing cost on your rental property.

 

Closing Costs That Increase Your Basis

Other closing costs on a rental property need to be added to the property basis and then recovered over time with depreciation. Your initial cost basis when you buy a rental property is the price paid for the property. After that, certain closing costs are added to the initial basis to arrive at an adjusted basis.

Settlement fees and closing costs that become additions to your basis include:

  • Abstract fees
  • Utility installation service charges
  • Legal fees
  • Recording fees
  • Surveys
  • Transfer taxes
  • Title insurance

Costs that a seller normally owes that a buyer agrees to pay for (all or in part), such as back property taxes or sales commissions, are also added to the property basis.

A good way to think about items that increase your basis is as costs that add value or improve your rental property, versus repairs and maintenance that keep the property in good operating condition. 

IRS Publication 551, Basis of Assets, explains in detail how to increase basis. In general, real estate investors can follow the BAR Rule to determine if an expense is an improvement that must be depreciated:

  • Betterment
  • Adaptation
  • Restoration
  • BAR = Improvement = Depreciation

Why Basis is Important

Depreciation is a non-cash expense that you can use to reduce your taxable net income. The bigger your basis is the better because your depreciation expense will be higher and your taxable rental income lower.

Here’s how a large amount of depreciation can reduce rental income tax. To calculate the depreciation expense we need to do two things:

  1. Deduct the value of the land or lot from the basis, because land does not depreciate.
  2. Divide this amount by 27.5 years to determine the annual depreciation expense allowed by the IRS.

For example, let’s assume the basis on a rental home is $160,000 including the purchase price and closing costs that must be added to the basis. If the value of the lot is $15,000 the total basis available for depreciation is $145,000 and our annual depreciation expense is $5,273:

  • $160,000 Property Price + Depreciable Closing Costs
  • $160,000 – $15,000 Lot Value = $145,000 Value for Depreciation
  • $145,000 / 27.5 Years = $5,273 Annual Depreciation Expense

The depreciation expense is then used to reduce or even eliminate the amount of taxable income. If the rental property generated a net income of $4,000 after deducting normal operating expenses, the depreciation expense of $5,273 would reduce the amount of taxable net income to $0:

  • Net income before depreciation expense = $4,000
  • Depreciation expense = $5,273
  • Taxable net income after depreciation = -$1,273

 

Top Tax Deductions for Rental Property Landlords

Depreciation and closing costs are just one of the many tax deductions that rental property landlords benefit from. Other top tax deductions for real estate investors include:

Repairs

Repairs and general maintenance expenses such as landscaping, plumbing and roof repairs, and seasonal inspection of the HVAC unit are all tax-deductible expenses landlords can take. 

Because repairs are done to maintain the home and not improve it, repairs are fully deductible the year the costs are incurred.

Professional Service Fees

Fees paid for property management, leasing, accounting, legal, financial planning, and even online tenant screening fees are another top tax deduction for rental property landlords.

Interest

While the principal part of the mortgage payment is not deductible (because it is used to pay down the loan liability on the balance sheet), interest expense is fully deductible. 

At the end of each year, your lender will send you a Form 1098 that breaks down the interest you’ve paid in the calendar year.

Travel

In-town auto expenses for going to and from your rental property can be deducted based on the actual expense or using the current IRS deduction of 56 cents per mile. 

Out-of-town travel expenses are generally deductible provided that the main purpose of the trip – and the majority of time spent on the trip – is used for purposes relating to your rental property.

Homeowners and Landlord Insurance

Insurance premiums paid for the rental property to provide coverage for fire, theft, and flooding are fully deductible, as is extra coverage for landlord liability insurance. 

Oftentimes insurance is included as part of the monthly mortgage payment, so be sure not to overlook this top rental property expense.

Depreciation

Depreciation is a non-cash expense used to reduce – or sometimes completely eliminate – the tax due on rental income. Rental property depreciation is one of the reasons why many wealthy real estate investors pay next to nothing in personal income tax.

Pass-Through Tax Deduction

Also known as the Qualified Business Deduction (QBI), the pass-through tax deduction allows an additional deduction of up to 20% of all qualified pass-through income from a rental property after deductions for all other costs have been made, such as operating expenses and depreciation.  

 

Final Thoughts on This Topic

Keeping track of tax-deductible closing costs on a rental property, along with all of the other expense deductions real estate investors are entitled to, can be time-consuming and complex. Fortunately, it doesn’t have to be that way. 

Stessa is a 100% free software system that makes tracking real estate investments simple and accurate. 

You can track property performance at a unit and portfolio level, link bank accounts to automate income and expense tracking, and maximize your rental income revenue with real-time insights and custom recommendations to match your unique investment strategy.