Most of the expenses related to your rental property business can be used to offset your tax liability at the end of the financial year, including several of the closing costs associated with an investment property. However, not all expenses can be deducted, some are non-deductible, and some you’ll need to add to the property’s cost basis and depreciate over time.
This article explores which rental property closing costs are tax-deductible, which can be deducted in a single year, and which ones need to be wrapped up with your cost basis and depreciated.
Rental Property Expenses
Many landlords confuse tax-deductible rental property expenses with capital expenses. However, while the concepts are similar the way you treat these expenses is very different and to maximize your deductions you need a clear understanding of these differences.
In short, capital expenses are those that need to be added to a property basis and depreciated over the useful lifetime. Generally speaking, capital expenses include things like property improvements, for example, a new kitchen that adds value to the property. However, some other larger expenses are also deemed by the IRS to be capital expenses.
On the other hand, tax-deductible expenses are deductible against that year’s taxable income and can be used to mitigate your tax liability. An example of a tax-deductible expense is necessary property maintenance expenses.
The Top Tax Deductible Expenses for Landlords:
- Interest
While your mortgage payments aren’t deductible, the interest on any loans that you have for your properties can be deducted from that year’s income.
- Depreciation
As already mentioned in this article, not every expense can be deducted in a single year. Instead, they need to be depreciated over time. The depreciation amount can then be deducted annually over the useful lifetime.
- Repairs
Repairs are made to maintain a property’s current standard. It’s important to note that any work that might be counted as an improvement to a property is not deductible.
- Personal Property
Personal property such as furniture and whiteware which is used in rental properties is seen as a business expense and is fully deductible.
- Pass-through Tax Deduction
Depending on your income landlord’s may be able to use the pass-through tax deduction. This allows you to deduct either (1) up to 20% of their net rental income, or (2) 2.5% of the initial cost of their rental property plus 25% of the amount they pay their employees.
- Travel
Costs gained through travel undertaken as part of the management of your property can be deducted – such as mileage costs, or even flights if your rentals are out of state.
- Employee and Independent Contractors
You can deduct the wages of anyone employed to perform services for your rental activity. Independent contractors include examples such as electricians or plumbers; whilst an employee is someone like a resident manager.
All the Insurance premiums you pay for your rental property, including, fire, theft, and flood insurance as well as any landlord liability insurance can be deducted.
- Legal and Professional Services
The final item on our list is the cost of legal and professional services. This can include fees paid to attorneys or accountants, as well as costs associated with the creation of legal documents and property management. Landlord Studio property management software falls under this category.
Capital Expenses, Depreciation, and your Basis
What is your rental property basis?
The basis is the value of an asset at the point when you acquire it. This can either be the price you paid for the asset or if you acquire a property through a process like inheritance you would base it on current market value.
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.
Additional Key Terms
- Depreciation
Depreciation is the deduction of the value of an asset over its useful life. For residential rentals the IRS deems the useful life to be 27.5 years, meaning you can depreciate the property basis over this period.
- Gain or loss on sale or exchange
This is in regards to any capital gains or potential losses upon the sale of an asset that will either increase or reduce your tax liability.
- Depletion
This refers to the inherent wealth of the land depleting as the resources are mined. This is most often used in regards to land used for oil and gas drilling.
- Amortization
Amortization typically refers to the process of writing down the value of either a loan or an intangible asset. Amortization schedules are used by lenders, such as financial institutions, to present a loan repayment schedule based on specific maturity date.
- Casualty losses
A casualty loss is any loss in value resulting from damage to the assets from an unexpected or unusual event. For example, damage to a property because of an unexpected storm – loss resulting from progressive deterioration through normal wear and tear.
What Rental Property Closing Costs do Landlords Need to Know About?
What Are Closing Costs?
Closing costs on an investment property are similar to what you would pay on an owner-occupied property, with a few important exceptions. Let’s begin with a quick review of the different types of closing costs to expect when you’re buying any type of real estate:
- Title fees, escrow fees, recording fees, and transfer taxes (depending on the state you’re buying in)
- Prepaids and impounds for items such as taxes and interest and HOA fees
- Loan fees such as application, origination, credit report, and underwriting
- Mortgage insurance which you have needed to take out if your down payment is less than 20%, which is the case with some FHA mortgages or VA loans.
- Due diligence fees such as property appraisal, inspection, termite and pest inspection, and survey
- Third-party professional fees such as an attorney or financial advisor
The Basics About Tax Deductible Closing Costs
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. These include abstract fees, charges for installing utility services, legal fees, recording fees, surveys, transfer taxes, title insurance, and any amounts the seller owes that you agree to pay (back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions).
Costs that are basis adjustments can be part of your yearly depreciation deduction for the rental property.
There are also several closing costs that can’t be deducted and aren’t added to the basis. For this list, refer to IRS Publication 527 under the subheading Basis of Depreciable Property.
What are abstract and recording fees?
Property documents including deeds, mortgages, litigations, tax sales, and so on are included in the Abstract. It also includes a list of all the people that owned the property, and when they owned it. Recording Fees are for the filing of the Deed and your mortgage within your County.
What Closing Costs are Tax-Deductible on a Rental Property?
You can deduct the following three closing costs right away for your rental property. These are:
- 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
While the mortgage payment itself is not deductible the interest is. This though does not include any of the costs associated with the cost of getting the mortgage, such as the commission, abstract fees, or recording fees.
Keep in mind as well, that you cannot deduct the prepaid 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 circ*mstances.
Mortgage Points
Mortgage points represent certain charges paid to get the mortgage on your rental property and cover expenses, such as:
- Identity verification services
- Paperwork preparation and review
- Credit check fees and related expenses
Unfortunately, you generally will only be able to deduct some mortgage points in one year. The rest will need to be treated as 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.
Final Words
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.
To ensure you aren’t missing any deductions and are not over-paying your taxes at the end of the year it’s recommended that you employ a quality income and expense tracking tool such as Landlord Studio to keep track of your annual depreciable amounts. In Landlord Studio you can do this by setting up your depreciable amounts as a recurring expense. You can adjust this recurring expense at any time should your property basis change due to new capital expenses accrued over the financial year. Then at the end of the year run a financial report such as an Income Expense Statement or Schedule E report to determine the total deductible amount.
However, accurately determining your cost basis can be tricky, to ensure you account for everything you might want to use a tax preparation service that knows the ins and outs of this complicated aspect of being a landlord and can help ensure you are maximizing deductions which could potentially save you thousands of dollars.
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