Can You Write Off Closing Costs on a Rental Property?
The tax rules for rental property closing costs are complex. Understand how to properly account for these expenses, some immediately and others over time.
When purchasing a rental property, investors face a variety of closing costs. These expenses, paid at the final stage of the transaction, represent a significant financial outlay beyond the property’s contract price. Understanding the correct tax treatment for each of these costs is a fundamental part of managing a real estate investment. The tax rules surrounding closing costs are specific, with different types of expenditures being handled in distinct ways. The way these costs are reported can influence annual taxable income and the ultimate calculation of gains or losses upon the sale of the property.
Immediately Deductible Closing Costs
A select few closing costs are treated as current rental expenses, meaning they can be deducted in the same year the property is acquired. This immediate deduction reduces your rental income for the year. The primary items in this category are prepaid mortgage interest, which is reported on Form 1098, and real estate taxes paid at closing. These are considered operating expenses because they relate to the current period’s costs of holding the property.
For example, if you close on a property in December, you may prepay the mortgage interest for that month, and this amount is deductible in the year you pay it. Similarly, property taxes are often prorated at closing, with the buyer paying their share for the portion of the year they will own the property. Certain insurance premiums might also qualify, but it is important to distinguish these from title insurance, which is handled differently.
Closing Costs Added to Your Property Basis
The majority of closing costs are not deducted immediately but are instead added to the property’s basis. A property’s tax basis is its acquisition cost for tax purposes, and adding these settlement fees increases this value, creating an “adjusted basis.” This process is referred to as capitalization. While it doesn’t provide an immediate tax write-off, it is a mechanism for recovering these costs over time.
These capitalized costs include a wide range of expenditures necessary to acquire the property. Common examples are abstract fees, legal fees associated with the purchase, recording fees paid to local governments, and the cost of land surveys. Additionally, expenses for title insurance, transfer taxes, and charges for installing utility services are included in the property’s basis. If as the buyer you agree to pay any amounts the seller owes, such as back taxes or sales commissions, these payments also become part of your adjusted basis.
Recovering Capitalized Costs Through Depreciation
The higher adjusted basis created by capitalizing closing costs provides a long-term tax benefit through depreciation. Depreciation is the annual deduction that allows you to recover the cost of your rental property, including the capitalized closing costs, over its designated useful life. For residential rental properties, the Internal Revenue Service (IRS) has determined this useful life to be 27.5 years.
To calculate the annual depreciation deduction, you first determine the adjusted basis of the building. The value of the land is not depreciable and must be subtracted from the total adjusted cost. The remaining amount is then divided by 27.5 to find the annual depreciation expense you can claim. For instance, if a property has an adjusted basis of $300,000, with $50,000 allocated to land, the depreciable basis is $250,000. This results in an annual depreciation deduction of approximately $9,091, which reduces your taxable rental income each year.
Special Treatment for Loan Costs
Costs associated with obtaining a mortgage to purchase the rental property receive unique tax treatment. These expenses are not immediately deductible nor are they added to the property’s basis for depreciation. Instead, costs such as loan origination fees, points, and mortgage insurance premiums must be amortized, or deducted in equal portions, over the life of the loan. This separates the cost of financing from the cost of the property itself.
For example, if you pay a $3,000 loan origination fee on a 30-year mortgage, you would be entitled to an annual deduction of $100 ($3,000 divided by 30 years). This annual deduction is claimed each year the mortgage is in place. This treatment differs significantly from the 27.5-year depreciation schedule for the building, reflecting that the loan’s life is distinct from the property’s useful life.
How to Report Costs on Your Tax Return
Immediately deductible expenses, such as prepaid mortgage interest and real estate taxes, are reported on Schedule E (Form 1040), Supplemental Income and Loss, on their designated lines. The annual depreciation deduction, which includes the capitalized closing costs, is calculated on Form 4562, Depreciation and Amortization. The total depreciation amount from this form is then carried over and entered as an expense on Schedule E. Similarly, the amortized costs of obtaining a loan are also reported on Schedule E, typically listed under the “Other Expenses” category with a clear description.