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.
Generally speaking, you can write off a variety of closing costs, including prepaid mortgage interest, title charges and recording fees.
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.
- Rental Software: Real Estate Investors Beware: The Capital Gains Unrecaptured Section 1250 Gain Tax Trap
- IRS. "Publication 551 (Rev. December 2018) Cat. No. 15094C Basis of Assets." Page 2. Accessed June 23, 2020.
- IRS. "Publication 551 (Rev. December 2018) Cat. No. 15094C Basis of Assets." Page 5. Accessed June 23, 2020.
- IRS. "Topic No. 701 Sale of Your Home." Accessed June 23, 2020.
- IRS. "Publication 544 Cat. No. 15074K Sales and Other Dispositions of Assets." Page 27. Accessed June 23, 2020.
- IRS. "Publication 551 (Rev. December 2018) Cat. No. 15094C Basis of Assets," Page 2-3. Accessed June 23, 2020.
- IRS. "Publication 551 (Rev. December 2018) Cat. No. 15094C Basis of Assets." Page 4-5. Accessed June 23, 2020.
- IRS. "Publication 946 Cat. No. 13081F How to Depreciate Property." Accessed June 23, 2020.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.