What Closing Costs are Deductible?

There are many closing costs associated with purchasing rental real estate. These closing costs are reported on your Closing Disclosure and, for tax purposes, are treated as one of the following:

• Currently deductible cost
• Cost added to the “loan basis” and amortized over the life of the loan
• Cost added to the “building basis” and depreciated

The costs added to either the loan or building basis are referred to as “facilitative” costs. We’ll break down what that means shortly, but in the meantime, your citation for adding closing costs to the loan or building basis is IRS Reg. Sec. 1.263(a)-2(f).

Currently Deductible Costs

“Currently deductible” means that you report these costs on Schedule E. You do not add these costs to basis and amortize/depreciate.

Many accountants make the mistake of simply deducting ALL closing costs or depreciating ALL closing costs. However, this is often not correct.

Closing costs that are currently deductible generally fall into the following categories:

• Daily interest
• Real estate taxes
• HOA dues
• Prepaid 12 month insurance

It’s important to understand that payments made to escrow at closing and through your monthly mortgage payments are NOT immediately deductible. These costs are only deductible when escrow releases the funds to pay expenditures (such as annual property taxes and insurance renewals).

The daily interest will most likely be reported on Form 1098 so not much to worry about there.

One interesting thing to note related to property taxes is that there is typically a property tax adjustment shown on your Closing Disclosure. If I pay for 12 months of property taxes in January, and then sell the property to you in February, I should have only paid one month of property taxes. But because I pre-paid the entire year, we have to make an adjustment at closing to show that I only paid one month and you are paying the remaining 11 months.

When a property tax adjustment increases your cash needed to close, it’s treated as an expense on Schedule E. This makes sense… you’re having to come out of pocket for an additional amount of money so it should be an expense to you.

When a property tax adjustment decreases your cash needed to close, it’s treated as a “negative” expense or as income. You may see this property tax credit in situations where the buyer offers to “pay” your share of the property taxes or otherwise provide a property tax credit to you.

Closing Costs Added to Loan Basis

If you buy property all cash, you don’t need to worry about loan costs. But when you use financing, the lender will charge you a myriad of fees. Fees associated with obtaining financing are added to your balance sheet and “amortized” (similar to depreciation) over the lifetime of the loan.

Typical loan costs include:

• Appraisal fees
• Credit report fees
• Application fees
• Origination fees
• Points
• Certain escrow fees (not pre-payments)
• Document fees
• Title fees
• Survey fees

The good news is that these loan fees are summarized for you on Page 2, Line D “Total Loan Costs” of your standard closing disclosure. You can generally take that amount and add it right to your balance sheet.

Closing Costs Added to Building Basis

Other facilitative costs that haven’t been listed above are added to the building basis and depreciated over either 27.5 or 39 years depending on what type of property you are closing on.

These facilitative costs are amounts you spend in the process of investigating rental real estate that you purchase. Examples of facilitative costs that you add to the building basis are:

• Inspection fees
• Architecture / Engineering fees
• Legal fees and title examinimation fees
• Recording fees
• Document fees (if not associated with the loan)
• Brokers fees
• Finders fees
• Conveyance costs and transfer taxes
• HOA registration/review fees
• Impound fees or tax stamps
• 1031 exchange fees

These costs will not be as easy to identify as lending fees above. They are reported in the “Other Costs” section of your closing disclosure as are currently deductible expenses that we covered above. This requires that you sift through your closing disclosure to pull out and bucket fees that are added to the building basis and fees that are currently deductible.

Takeaways

When purchasing rentals it’s important to know that fees associated with the acquisition are either deductible or added to the loan or building basis.

Costs that are currently deductible are taken on Schedule E.

Costs that are associated with obtaining financing are “capitalized” as Loan Costs and amortized over the life of the loan.

Other costs that are facilitative in nature are added to the building’s basis and depreciated over 27.5 or 39 years.