The Internal Revenue Service is much more generous with rental properties than with personal residences. With rental property, you get the opportunity to deduct some expenses, amortize others, and add others to your basis. Everything you spend to close a rental property eventually ends up as an expense that reduces your taxable rental income.
Understanding Basis Adjustments
Many closing costs get added to your cost basis. Since they increase your cost basis, they let you claim more depreciation while you own the property. They can also reduce the amount of your eventual sale proceeds that are subject to capital gains tax since a higher cost basis reduces your profitability. Closing costs that get applied to your basis include title charges, recording fees and transfer taxes as well as any additional settlement charges, like pest inspections or surveys.
Tax-Deductible Closing Costs
Closing costs that you'd normally write off for your personal residence are deductible for a rental home as well. For instance, you can write off prepaid mortgage interest and prorated property taxes. Contributions to an escrow account for future property taxes or property insurance are also deductible, as long as the money that funds the account will be spent in the same tax year. Your write-offs will be reduced, though, by any amount that the seller pays for you.
Amortizable Closing Costs
When you take out a mortgage, the IRS lets you write off your interest, but you will have to amortize your closing costs over the life of the loan. Closing costs like prepaid interest, loan origination fees and even "junk" charges like appraisal fees or documentation fees all get divided over the life of your loan. If you took out a 25-year amortization loan with a 10-year term and you spent $16,000 to do it, you would divide the $16,000 by 10 to find your yearly amortization allowance. You can then write off $1,600 per year during the life of your loan.
When You Sell
The costs that you added to your basis can both help and hurt you when you sell. Since your capital gain is calculated as the difference between your net selling price and your adjusted cost basis, increasing your basis with closing costs reduces your potential profit, which reduces your potential capital gains liability. However, since you also claimed more depreciation due to your higher basis, you could end up paying more depreciation recapture tax if you sell the property for more than your depreciated basis. An accountant can help you strategize on ways to minimize your tax liability on the sale.
