From Mark Minassian
Your Guide to Business Law / Taxes: U.S..
In my article on tax deductions for landlords, I talked about expenses that may be deductible when incurred on an investment property. But a big area of confusion comes when a real estate investor pays closing costs in connection with getting the mortgage on a rental property. Since closing costs can run anywhere from 1% to 5% of the loan value, they represent a significant cash outlay. However, not all of the closing costs are deductible as a current expense.
Closing costs on an investment property may fall into one of three tax categories:
• Deductible as a current expense – These amounts are deducible in full as a rental expense in the year the property is purchased
• Amortized over the life of the loan – These amounts must be deducted evenly over the total number of loan payments required at the beginning of the loan
• Added to the cost basis of the property – These amounts must be added to the cost basis
(i.e. the purchase price) of the property and must be depreciated
Before we look at each line item on a closing statement (also known as a HUD-1 statement), you should download a blank HUD-1 statement to follow along.Note: The tax treatment of the items below relate to a purchase of an investment property. The tax treatment of some of these items when paid in connection with the purchase of a principal residence is different.
HUD-1 Statement Line-by-Line – Page 1
100. Gross Amount Due From Borrower
• 101. Contract sales price – This is the purchase price of the property and must be depreciated.
Mark’s tip: Unless you are buying a condo, you must allocate part of this purchase priceto the land that the house or building sits on. The cost allocated to the land may not be deducted, depreciated or amortized. The amount that should be allocated to the land will vary based on the size and location of the property, but it is common practice to allocate 10% to 25% of the purchase price to the land.
• 102. Personal property – This is the purchase price of any personal property included with the property and must be depreciated.
• 103. Settlement charges to borrower (line 1400) – These are the total of the costs that appear on page two of the HUD-1 statement and are discussed below.
Adjustments for items paid by seller in advance
• 106. City/town taxes – These are allowed as a current rental deduction but must be reduced by any amount on Line 210• 107. County taxes – These are allowed as a current rental deduction but must be reduced
by any amount on Line 211
• 108. Assessments – These are allowed as a current rental deduction but must be reduced by any amount on Line 212. However, if the assessments are specifically labeled as localimprovement district (LID) assessments, they are not currently deductible and must beamortized over the life of the loan.
200. Amounts Paid By Or In Behalf Of Borrower
• 201. Deposit or earnest money
• 202. Principal amount of new loan(s)
• 203. Existing loan(s) taken subject to
These amounts are all included in the purchase price on lines 101 and 102 above. The amounts on lines 201, 202 and 203 do not get separately deducted or amortized, but the interest paid over the life of the mortgage is deductible when paid.
Adjustments for items unpaid by seller
210. City/town taxes
211. County taxes
These amounts reduce any deductible amounts on lines 106, 107 and 108 above.
HUD-1 Statement Line-by-Line – Page 2
700. Total Sales/Broker’s Commission– This is paid by the seller and has no tax effect on the buyer.
800. Items Payable In Connection With Loan
• 801. Loan origination fee
• 802. Loan discount
These items must be amortized over the life of the loan.
Mark’s tip: Many people think that these amounts (usually referred to as points) are a current tax deduction. However, the only time that points are allowed as a current deduction is if the points are paid in connection with the purchase of a primary residence. Points paid in connection with the purchase of an investment property or paid on a refinancing of a personal residence or an investment property must be amortized over the life of the loan.
• 803. Appraisal fee – Added to the cost basis of the property (line 101) and must be depreciated.
• 804. Credit report – Added to the cost basis of the property (line 101) and must be depreciated.
• 805. Lender’s inspection fee – Added to the cost basis of the property (line 101) and must be depreciated.
• 806. Mortgage insurance application fee – Amortized over the life of the loan
• 807. Assumption fee – Amortized over the life of the loan
900. Items Required By Lender To Be Paid In Advance
• 901. Prorated interest – Deductible as a current rental expense.
Mark’s tip: This amount will usually appear on Form 1098 that you will receive at the end of the year showing how much interest you paid during the year. However, not all lenders include this amount on the form so be sure to check with your lender to find out.• 902. Mortgage insurance – Amortized over the period the payment covers, which is usually one year
• 903. Hazard insurance – Amortized over the period the payment covers, which is usually one year
1000. Reserves Deposited With Lender
1001. Hazard insurance.
1002. Mortgage insurance.
1003. City property taxes
1004. County property taxes.
1005. Annual assessments
These amounts are deposited (escrowed) with the lender and are deductible when they are disbursed from escrow by the lender. These amounts paid from escrow should be reported on your Form 1098 at the end of the year.
1100. Title Charges
1101. Settlement or closing fee
1102. Abstract or title search
1103. Title examination
1104. Title insurance binder.
1107. Attorney’s fees
1108. Title insurance
1109. Lender’s coverage
1110. Owner’s coverage
All of these amounts are added to the cost basis of the property (line 101) and must be depreciated.
1200. Government Recording and Transfer Charges
• 1201. Recording fees
• 1202. City/county tax/stamps
• 1203. State tax/stamps
These amounts are added to the cost basis of the property (line 101) and must be depreciated.
1300. Additional Settlement Charges
• 1301. Survey
• 1302. Pest inspection
These amounts are added to the cost basis of the property (line 101) and must be depreciated. There may be other miscellaneous closing costs that you may pay in connection with buying an investment property. While the tax treatment of these amounts may vary, the general rule of thumb is that the costs associated with buying or operating the property (such as real estate taxes and insurance) are deductible and the costs associated with obtaining the mortgage (such as title and recording fees) must be added to the cost basis of the property.
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