Tax deductions are a great way to save money at tax time every year. Taking full advantage of tax deductions and knowing what rental property closing costs are tax deductible will save you thousands of dollars over time, especially when it comes to purchasing a rental property.
Every expense related to your rental should be used to offset your income, and there are quite a few closing expenses that will help you decrease your overall taxable rental income. The IRS is a bit more generous when it comes to rental properties compared to deducting costs related to your personal residential property.
However, you cannot simply deduct all of your expenses. Instead, part of the closing costs and related fees become wrapped up in your basis and are deprecated over time. This article explores what that means right away to immediately decrease your taxable income this year.
Rental Income Expenses
Rental expenses are sometimes confused with your capital expenses, especially when you first purchase your rental property. While the concepts are similar, they are not the same.
A rental expense is deducted directly from your income. It offsets your income dollar-for-dollar right away. These reduce the taxable income that you have for your rental property.
Expenses are ongoing, and they will sometimes occur on a recurring basis, such as annually or monthly. Some of the most common expenses include:
- Cleaning and maintenance
- Management fees
- Legal and professional fees
- Mortgage interest
Each of these expenses is classified as either normal expenses/deductions or capital expenses.
A typical rental expense will be listed on your Schedule E and subtracted from your rental income immediately. It will result in a lower taxable income for your rental property.
A capital expense also lowers your taxable income, but it may not be a dollar-for-dollar reduction. Instead, it affects the tax basis of your property, and it will be deducted over time. Capital expenses, including things like additions, repairs, or other improvements.
Your Basis and Capital Expenses
What Does “Basis” Mean?
Your “basis” in an asset is the investment that you used to acquire the asset. In most cases, it is the price that you paid for the asset, but it can also be based on market value rather than price if you acquired the property as a gift or through inheritance.
The basis of a property is important for tax purposes because you use it to determine a variety of information that affects your income taxes, including concepts like:
- Gain or loss on sale or exchange
- Casualty losses
For rental properties, your basis will be important to determine your annual deprecation and, when you are ready to sell, how much gain or loss you realized for the property.
What is Included in the Basis?
The basis of your rental property means more than just the price that you paid to purchase the property. It also includes a variety of other costs that you had to incur to finalize the sale. Costs wrapped into the basis will often include things like:
- Transfer or sales taxes
- Abstract fees
- Title insurance or the costs of a title opinion
- Recording fees
- Legal fees
It also includes any other amount that you, as the buyer, agree to pay to acquire the property, such as sales commissions, back taxes, or interest. You can even include things like installing utility services on the property.
Why Does Basis Matter?
Your basis matters because it allows you to increase the total amount that you can depreciate over time and is used to determine what rental property closing costs are tax deductible. The term “deprecation” is an accounting method that helps you realize the fact that an asset will usually decrease in value over time. It enables you to capture this decrease in value in real dollars and cents.
Depreciation is an expense that decreases your taxable income from your rental property, without having to spend any additional dollars. It simply accounts for the decrease in the value of your property over the useful life of the asset.
An asset is depreciated over the term of its “useful life,” as defined by the internal revenue service. For example, your rental property is likely going to have a much longer useful life compared to your car simply because it is real property.
You cannot use deprecation to offset your income whenever you would like, however. Instead, you must use a designated depreciation schedule. For real property, that schedule is over a period of 27.5 years (under a method called Modified Accelerated Cost Recovery System or MACRS). That means that you take the total basis of the property, divide it by 27.5, and that is the amount that you can depreciate each year. This method is referred to as “straight-line depreciation.” While not every type of deprecation uses this method, most do.
Of course, the higher the basis of the property, the more your depreciation expense each year will be—and the higher your depreciation, the lower your taxable income from your rental property will be. Deprecation can be a huge tax savings for those who own rental property.
Are There Any Other Need-to-Know Adjustments to the Basis?
Keep in mind that your basis has nothing to do with how much you paid in cash for the real property. The basis is the total cost, including expenses, regardless of whether you have a mortgage on the property or not.
You should also note that you can only depreciate the rental property itself—the building. Land does not depreciate, at least according to the IRS. That means that you will likely have to decrease the basis by the value of the land, and you can usually find that information as part of your property tax assessment from your local county, city, or other taxing authority.
Your basis will also be affected by any improvements you make to the property. This is particularly relevant if you are improving the property before you place it into service to rent. The basis can also decrease if there is substantial damage to the rental as well.
Basis, Closing Costs, and Capital Expenses
Although you cannot deduct expenses directly, you indirectly deduct them by including them in your basis. As you depreciate the property, the costs used to close on the house will essentially be depreciated, as well. Therefore, you actually deduct the closing costs over time, rather than deducting most of them immediately when you purchase the real estate.
Closing costs are generally considered capital expenses because of this long-term depreciation scheme.
“True” Deductible Closing Costs
You can deduct just three closing costs right away for your rental property. These include:
- Interest on your mortgage
- Certain mortgage points
- Qualifying real estate taxes
In addition, you can only make some of these deductions if you itemize your return. In most situations, you will itemize if you have a rental property that you do not own outright, but that is not always the case. Your tax preparer will be able to tell you whether itemizing or using the standard deduction will give you higher tax savings.
Mortgage interest really includes just that—only the interest payments. It does not include the cost of getting the mortgage, such as the commission, abstract fees, or recording fees.
This expense will be reported by your lender just as if you were living in the property. Your lender will issue a Form 1098 if you paid over $600 in interest to that lender throughout the year. This information will be included on your Schedule E.
Keep in mind, however, that you cannot deduct pre-paid interest. You can only deduct interest as it would be incurred. In general, that is not an issue at closing, but it could be under some circumstances.
Mortgage points represent certain charges paid to get the mortgage on your rental property. They are, in a sense, prepaid interest. They also cover other expenses, such as:
- Identity verification services
- Paperwork preparation and review
- Credit check fees and related expenses
Original fees or points are often about 1% of the total value of the mortgage.
Your lender should also send you a Form 1098 to describe your deductible mortgage points as well. Unfortunately, you generally will not be able to deduct all of your mortgage points in one year. Instead, you will need to deduct this interest over the term of the loan—making a portion of your mortgage points a capital expense. Your lender should include all of this information for you on Form 1098.
Real Estate Taxes
You may also have to pay real estate taxes as part of the closing process. Any tax that you pay during the closing can be deducted as a normal rental expense.
Generally, the buyer will pay the property taxes that are due from the date of the closing until the end of the tax year. If the seller has already paid those taxes in advance, then the buyer still provides their pro-rated share. Even the pro-rated share can be deducted as an expense on your Schedule E.
Taking Advantage of All of Your Potential Tax Deductions
Unfortunately, some new landlords will make the mistake of not including their closing costs in their basis or not deducting some of their closing costs right away. Mistakes like these can cost you thousands of dollars over the useful life of your property.
You can avoid this type of issue by using a tax preparation service that knows the ins and outs of this complicated aspect of being a landlord and can help you determine what rental property closing costs are tax deductible. Learn more about our tax prep services by requesting a free consultation or reviewing our FAQ Section.