Are Mortgage Points Tax Deductible on a Rental Property?
Understand how mortgage points on a rental property are deducted over time, their tax implications, and key factors that affect eligibility and reporting.
Mortgage points can lower your loan’s interest rate, but they come at an upfront cost. For rental property owners, understanding whether these points are tax-deductible is essential for maximizing deductions and reducing taxable income. The IRS treats mortgage points on investment properties differently than those on a primary residence, affecting how and when they can be deducted.
Deductible Points vs. Non-Deductible Fees
When purchasing or refinancing a rental property, borrowers often pay mortgage points to secure a lower interest rate. The IRS classifies these points as prepaid interest, meaning they must be deducted over time rather than in a single year. Unlike points on a primary residence, which may be fully deductible in the year paid, points on an investment property must be amortized over the loan’s term.
Not all closing costs qualify as deductible points. Fees such as loan origination, underwriting, and processing charges are considered service costs, not interest. These expenses cannot be deducted as mortgage interest but may be added to the property’s basis and depreciated. Misclassifying these costs can lead to tax errors and potential issues if audited.
To qualify as deductible interest, points must be a percentage of the loan amount and explicitly labeled on the settlement statement. They must also be paid directly to the lender rather than allocated to property taxes or escrow reserves. If these conditions are not met, the expense cannot be deducted as mortgage interest.
Allocation of Points Over the Loan Period
Mortgage points on a rental property must be deducted gradually. The IRS requires amortization over the loan’s duration, meaning the deduction is spread evenly across each year of the mortgage term. For example, if a borrower pays $3,000 in points on a 30-year loan, they can deduct $100 per year.
The deduction is reported as mortgage interest on Schedule E, which covers rental income and expenses. If the rental property generates sufficient income, this deduction helps offset taxable earnings. However, if the property operates at a loss, passive activity loss rules may limit the deduction unless the taxpayer actively manages the rental.
If the loan has an interest-only period before transitioning to principal and interest payments, amortization remains based on the original loan term. If a borrower refinances with the same lender and rolls the remaining unamortized points into the new loan, the deduction may need adjustment based on the new mortgage terms.
Impact of Refinancing or Early Loan Payoff
Refinancing or paying off a loan early affects the remaining balance of unamortized points. If a rental property loan is refinanced with a different lender, any undeducted points from the original loan can often be written off in full in the year of refinancing. However, if refinancing occurs with the same lender, the IRS typically requires the remaining points to be spread over the new loan’s term rather than deducted immediately.
Paying off a loan ahead of schedule allows the remaining unamortized points to be deducted in the year of payoff. This can create a larger deduction in that tax year, reducing taxable rental income more significantly than in prior years. If the rental property is sold rather than refinanced or paid off early, the remaining points are not deducted as an expense but are instead factored into the property’s adjusted cost basis, affecting capital gains calculations when reporting the sale.
Documenting and Reporting Points
Accurate documentation is necessary when claiming a deduction for mortgage points on a rental property. The IRS requires clear records, making it important to retain the loan’s closing disclosure or settlement statement, which itemizes the amount paid in points. These documents should be kept alongside the loan agreement to verify the mortgage term, as the deduction is spread over its duration. Proof of payment, such as bank statements or wire transfer records, should also be maintained to confirm that the points were paid directly to the lender rather than financed into the loan amount.
When reporting points on a tax return, they are categorized as interest expense on Schedule E, which is used to report rental property income and expenses. Unlike interest on personal residences, which is reported on Schedule A for itemized deductions, rental property interest is deducted as a business expense, directly offsetting rental income. If multiple rental properties are owned, each must be reported separately to ensure expenses are allocated correctly.