The Rules Around Deducting Closing Costs on Rental Property (2022)

If you recently purchased a rental property, you may be wondering what closing costs you can deduct. After all, even though the Internal Revenue Code is extremely friendly to real estate investors, there’s no reason to pay more in tax than you should.

In one way or another, all closing costs on a rental property are deductible, but they are expensed in different ways. Some costs you can write off right away, while other expenses you have to deduct over time.

Here’s a look at how closing costs on rental property work, along with some tips that can reduce or even eliminate the tax you pay on rental property income.

What Are Closing Costs?

Closing costs on a rental property are the fees and expenses paid to close escrow, above and beyond the down payment you make for the home.

These costs generally run between 2% – 5% of the loan amount and are similar to the fees you would pay for an owner-occupied home. However, most title companies offer a discount for real estate investors, so the actual closing fees you pay as a rental property buyer may be a little lower than what the average homeowner would pay.

The financial technology company SmartAsset has put together a Closing Costs Calculator to help understand the total closing costs and the amount needed at settlement based on the property location, home price, and down payment.

The types of closing costs to expect when you buy a rental property include:

  • Inspection fees for a property appraisal, home inspection, termite and pest inspection, and in some areas a survey and septic inspection, if the property is located in a rural area.
  • Professional fees paid to an attorney or financial advisor to assist you with drawing up and reviewing the closing documents.
  • Mortgage fees such as loan application, credit report, origination, and underwriting fees.
  • Prepaid and impound amounts for property taxes, mortgage interest, homeowners insurance, and HOA fees.
  • Title company fees include escrow fees, recording fees, transfer taxes, and title search.
  • Real estate investors who make a down payment of less than 20% will also be charged a mortgage insurance premium (MIP) with some FHA or VA home loans.

The Rules Around Deducting Closing Costs on Rental Property (1)

(Video) What closing costs are tax deductible for my rental property?

Deductible Closing Costs on Rental Property

Closing costs on a rental property are often accounted for in two different ways. Some costs to buy a home can be completely expensed right away, while others have to be added to the property basis and depreciated over time.

Let’s begin by discussing the deductible closing costs on a rental property that can be deducted right away. According to the IRS, there are only three closing costs that can be deducted in the same year the property is purchased:

Mortgage Interest

As a rental property investor, you can deduct the interest part of your mortgage payment but not the principal payments, because those are used to reduce the mortgage loan liability on the property balance sheet.

Each year your lender will issue a Form 1098 to report the interest paid on the loan throughout the year.

Mortgage Points

A mortgage point, also known as a discount point, is paid directly to the lender in exchange for a lower interest rate. Each mortgage point equals about 1% of the loan value and covers expenses such as borrower verification services, document preparation and review, and credit check and related fees.

Not all of the mortgage point expenses are deductible right away. Instead, some portion of the total mortgage point cost will need to be added to your property basis and deducted over the term of the loan. Form 1098 that you receive from your lender will break down the amount that can be expensed right away and those that must be deducted over time.

Deductible Real Estate Taxes

Real estate property taxes are the third deductible closing cost on a rental property.

Real estate taxes are prorated from the day you purchase the property through the end of the year and are deducted in full for each year that you own the property. For example, if property taxes are $2,700 for the year and you close escrow on June 1st, you would be entitled to deduct the remaining seven months of property taxes.

In some cases, you may close on a property where the seller has already paid the property taxes for the entire year. When that occurs, on the closing settlement statement you will receive a debit or charge to credit the seller for real estate taxes she paid when you actually own the property.

(Video) How to Deduct Closing Costs on Your Rental Property - Tax Deductions

That prorated share of real estate property taxes can still be deducted as a closing cost on your rental property.

The Rules Around Deducting Closing Costs on Rental Property (2)

Closing Costs That Increase Your Basis

Other closing costs on a rental property need to be added to the property basis and then recovered over time with depreciation. Your initial cost basis when you buy a rental property is the price paid for the property. After that, certain closing costs are added to the initial basis to arrive at an adjusted basis.

Settlement fees and closing costs that become additions to your basis include:

  • Abstract fees
  • Utility installation service charges
  • Legal fees
  • Recording fees
  • Surveys
  • Transfer taxes
  • Title insurance

Costs that a seller normally owes that a buyer agrees to pay for (all or in part), such as back property taxes or sales commissions, are also added to the property basis.

A good way to think about items that increase your basis is as costs that add value or improve your rental property, versus repairs and maintenance that keep the property in good operating condition.

IRS Publication 551, Basis of Assets, explains in detail how to increase basis. In general, real estate investors can follow the BAR Rule to determine if an expense is an improvement that must be depreciated:

  • Betterment
  • Adaptation
  • Restoration
  • BAR = Improvement = Depreciation

Why Basis is Important

Depreciation is a non-cash expense that you can use to reduce your taxable net income. The bigger your basis is the better because your depreciation expense will be higher and your taxable rental income lower.

Here’s how a large amount of depreciation can reduce rental income tax. To calculate the depreciation expense we need to do two things:

(Video) Rental Real Estate Closing Costs Explained [Tax Smart Daily 030]

  1. Deduct the value of the land or lot from the basis, because land does not depreciate.
  2. Divide this amount by 27.5 years to determine the annual depreciation expense allowed by the IRS.

For example, let’s assume the basis on a rental home is $160,000 including the purchase price and closing costs that must be added to the basis. If the value of the lot is $15,000 the total basis available for depreciation is $145,000 and our annual depreciation expense is $5,273:

  • $160,000 Property Price + Depreciable Closing Costs
  • $160,000 – $15,000 Lot Value = $145,000 Value for Depreciation
  • $145,000 / 27.5 Years = $5,273 Annual Depreciation Expense

The depreciation expense is then used to reduce or even eliminate the amount of taxable income. If the rental property generated a net income of $4,000 after deducting normal operating expenses, the depreciation expense of $5,273 would reduce the amount of taxable net income to $0:

  • Net income before depreciation expense = $4,000
  • Depreciation expense = $5,273
  • Taxable net income after depreciation = -$1,273

The Rules Around Deducting Closing Costs on Rental Property (3)

Top Tax Deductions for Rental Property Landlords

Depreciation and closing costs are just one of the many tax deductions that rental property landlords benefit from. Other top tax deductions for real estate investors include:

Repairs

Repairs and general maintenance expenses such as landscaping, plumbing and roof repairs, and seasonal inspection of the HVAC unit are all tax-deductible expenses landlords can take.

Because repairs are done to maintain the home and not improve it, repairs are fully deductible the year the costs are incurred.

Professional Service Fees

Fees paid for property management, leasing, accounting, legal, financial planning, and even online tenant screening fees are another top tax deduction for rental property landlords.

Interest

While the principal part of the mortgage payment is not deductible (because it is used to pay down the loan liability on the balance sheet), interest expense is fully deductible.

At the end of each year, your lender will send you a Form 1098 that breaks down the interest you’ve paid in the calendar year.

(Video) Rental Property Tax Deductions - Deducting Rental Expenses When No Income

Travel

In-town auto expenses for going to and from your rental property can be deducted based on the actual expense or using the current IRS deduction of 56 cents per mile.

Out-of-town travel expenses are generally deductible provided that the main purpose of the trip – and the majority of time spent on the trip – is used for purposes relating to your rental property.

The Rules Around Deducting Closing Costs on Rental Property (4)

Homeowners and Landlord Insurance

Insurance premiums paid for the rental property to provide coverage for fire, theft, and flooding are fully deductible, as is extra coverage for landlord liability insurance.

Oftentimes insurance is included as part of the monthly mortgage payment, so be sure not to overlook this top rental property expense.

Depreciation

Depreciation is a non-cash expense used to reduce – or sometimes completely eliminate – the tax due on rental income. Rental property depreciation is one of the reasons why many wealthy real estate investors pay next to nothing in personal income tax.

Pass-Through Tax Deduction

Also known as the Qualified Business Deduction (QBI), the pass-through tax deduction allows an additional deduction of up to 20% of all qualified pass-through income from a rental property after deductions for all other costs have been made, such as operating expenses and depreciation.

Final Thoughts on This Topic

Keeping track of tax-deductible closing costs on a rental property, along with all of the other expense deductions real estate investors are entitled to, can be time-consuming and complex. Fortunately, it doesn’t have to be that way.

Stessa is a 100% free software system that makes tracking real estate investments simple and accurate.

You can track property performance at a unit and portfolio level, link bank accounts to automate income and expense tracking, and maximize your rental income revenue with real-time insights and custom recommendations to match your unique investment strategy.

(Video) How To DEDUCT Rental Property Losses and REDUCE Taxes On other Types of Income

FAQs

Are closing costs tax deductible on sale of rental property? ›

Only loan interest and real estate taxes are deductible closing costs for a rental property. Other settlement fees and closing costs for buying the property become additions to your basis in the property.

Can you write off closing costs refinance for rental property? ›

Which ones are Deductible? Most closing costs for the refinance of an investment property are not deductible. The mortgage interest and property taxes can be deducted, but the rest are added to the cost basis for the asset and are depreciated.

Can I deduct closing costs from taxes? ›

Can you deduct these closing costs on your federal income taxes? In most cases, the answer is “no.” The only mortgage closing costs you can claim on your tax return for the tax year in which you buy a home are any points you pay to reduce your interest rate and the real estate taxes you might pay upfront.

What expenses can be deducted from sale of rental property? ›

Expenses to fix up a rental property for sale are generally tax deductible in the year the expense is incurred.
...
Other Expense Deductions When a Rental Property is Sold
  • Real estate commissions.
  • Legal fees.
  • Transfer taxes.
  • Title policy fees.
  • Deed recording fees.

Can you subtract closing costs from capital gains? ›

Capital Gains Tax

The price you paid for the home is also called the tax basis. The closing costs associated with selling the rental property that are tax deductible, discussed above, can be used to lower overall basis (or price you paid for the home), thus potentially lowering the capital gains tax.

What closing costs can be depreciated? ›

Generally, deductible closing costs are those for interest, certain mortgage points and deductible real estate taxes. Many other settlement fees and closing costs for buying the property become additions to your basis in the property and part of your depreciation deduction, including: Abstract fees.

Are closing costs expensed or capitalized? ›

In addition to the capitalized closing costs tied to your property, most costs associated with obtaining a loan must be capitalized rather than immediately deducted. These include loan origination/processing/underwriting fees, purchased points, appraisals, credit reports, etc. Add them up from your closing statement.

Are closing costs included in cost basis? ›

The main element in your home's basis is the purchase price. This includes your down payment and any debt, such as a mortgage. It also includes certain settlement or closing costs. If you had your house built on land you own, your basis is the cost of the land plus certain costs to complete the house.

How long do you amortize closing costs? ›

Closings costs on a rental property fall into one of three categories: Deduct upfront in the current year. Amortize over the loan term. Add to basis (capitalize) and depreciate over 27.5 years.

What is the standard deduction for 2022? ›

For the 2022 tax year, the standard deduction is $12,950 for single filers and married filing separately, $25,900 for joint filers and $19,400 for heads of household.

Is appraisal fee tax deductible for rental property? ›

The closing costs that are tax deductible on your rental property may include your attorney fees, state-required inspection fees, other legal fees, appraisal fees, and even your refinance application fee where applicable. Insurance and repair costs for the rental property are also typically tax deductible.

What are standard deductions? ›

For the 2022 tax year, the standard deduction is $12,950 for single filers, $25,900 for joint filers and $19,400 for heads of household. The deduction amount also increases slightly each year to keep up with inflation.

How do I figure the cost basis of a rental property? ›

How Do I Calculate Cost Basis for Real Estate?
  1. Start with the original investment in the property.
  2. Add the cost of major improvements.
  3. Subtract the amount of allowable depreciation and casualty and theft losses.

Are closing costs tax deductible on a second home? ›

If you paid points for a second home, the points can only be deducted (amortized) over the life of the loan. The remaining closing costs are not deductible however they should be added to the cost basis of the home.

How can I avoid paying tax on my rental income? ›

The good news is, you can reduce what you owe in income taxes on rental income by claiming deductions for depreciation and rental expenses, such as maintenance, upkeep and repairs. When you sell a rental property, you may owe capital gains tax on the sale.

What is the capital gains tax rate for 2022 on real estate? ›

In 2021 and 2022, the capital gains tax rate is 0%, 15% or 20% on most assets held for longer than a year. Capital gains taxes on assets held for a year or less correspond to ordinary income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% or 37%.

How does IRS verify cost basis? ›

Preferred Records for Tax Basis

According to the IRS, taxpayers need to keep records that show the tax basis of an investment. For stocks, bonds and mutual funds, records that show the purchase price, sales price and amount of commissions help prove the tax basis.

What can you claim to reduce capital gains tax? ›

One way to reduce the amount you pay is by increasing your property's cost base. This is the cost of acquiring, holding and disposing of a property, and is subtracted from the selling price to give you your capital gain. According to the ATO, the cost base of a CGT asset is made up of: The money you paid for the asset.

What expenses are deductible when selling a second home? ›

Because the home is considered a business, you can deduct rental expenses, including mortgage interest, property taxes, insurance costs, property manager fees, utilities, and property depreciation.

What expenses can be deducted from capital gains tax? ›

Selling Costs.

If you sell your home, you can lower your taxable capital gain by the amount of your selling costs—including real estate agent commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.

Are closing costs expensed or capitalized? ›

In addition to the capitalized closing costs tied to your property, most costs associated with obtaining a loan must be capitalized rather than immediately deducted. These include loan origination/processing/underwriting fees, purchased points, appraisals, credit reports, etc. Add them up from your closing statement.

Do you subtract mortgage payoff from capital gains? ›

The Internal Revenue Service doesn't let you deduct mortgages or liens when figuring the tax on capital gains from property sales, even though you must pay them off in order to sell with clear title. A mortgage is both contracted for and paid off during the buy-and-sell process, so it all evens out.

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