Although you cannot generally deduct costs associated with purchasing or refinancing your personal residence, you can normally deduct the closing and refinancing costs associated with a rental property. The difference is that your rental activities are part of a trade or business intended to generate a profit. The IRS allows business owners of whatever stripe to deduct legitimate and ordinary costs of doing business, including interest, closing and refinance charges on rental real estate. The precise procedure you use to deduct these costs depends on whether you own the real estate within a sole proprietorship, partnership, S-corporation or C-corporation. However, you cannot normally deduct the whole fee at once. Instead, you must spread your deduction over the expected useful life of the property in a process called "amortization."
Total up your fees for closing costs and related expenses to secure the new mortgage. Combine that figure with all your other capital expenditures for the year. This includes any expenditure you made to improve the property or your profitability in the property, minus deductions for minor and routine repairs.
Obtain or download a copy of IRS Form 4562. This form helps you calculate the amount of capital expenses you may claim in the current year for depreciation -- or the gradual decline in the expected value of the property as it nears the end of its useful life -- and amortization, which is the process of spreading your capital expenditures over the life of the property.
Complete Section IV of Form 4562. Enter your new expenses for your property on Line 23. Note that your tax basis in the property increased with the expenditure on the fee to acquire the loan. However, the amortization process will gradually lower your basis, all other things being equal, even as it lowers your tax bill.
Attach the completed Form 4562 to your tax return. If you file as an individual, then attach it to your Form 1040. If you own the property as part of an S-corporation, attach the form to your Form 1120 S. Do the same if you own the property in an LLC and you elected to have the IRS tax you as a corporation. If you own the property in a C corporation, then attach Form 4562 to your Form 1120, Corporate Tax Return.
Tips
Depreciation and amortization are advanced tax planning topics. There are several different methods for depreciating property. You may wish to consider obtaining the advice of a qualified tax professional for information pertaining to your specific situation.
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Homeowners can't deduct closing costs such appraisal fees, loan preparation fees, attorney fees or notary fees for a refinancing unless the property being refinanced is a rental property. You can deduct any points you pay to refinance the mortgage on either a rental property or your main home. Qualified points are interest you pay in advance to get a lower loan rate. A point equals one percent of the amount you borrow.
Deducting Points
When you refinance your home mortgage, you can usually deduct points you pay the lender as a mortgage-interest expense. You must itemize deductions on Schedule A to take the deduction. Normally, you deduct points over the life of the loan. To find out how much prepaid interest you can claim on your tax return, divide the points you paid by the number of monthly payments you will make during the loan term. This will give you the interest expense you can deduct per month. The total amount of interest you pay in the tax year is what you can deduct on Form 1040 Schedule SE -- Supplemental Income and Loss.
Home Improvements
If you use money from refinancing your mortgage to make improvements to your home, a portion of the points may be fully deductible in the year you paid them. The improvements must add value to your home to qualify. According to IRS guidelines, you must use your home as collateral for the loan. Paying points must be an established business practice in the area where you live and you can't pay more points than what lenders normally charge. In addition, you must use the cash method of accounting to report income and deduct expenses when you file your taxes. Also, a lender can't charge you points to waive other loan fees and the points you pay must be as much as the costs you pay to close the loan.
Rental Property
If you refinance the mortgage on a rental property, you can deduct expenses you paid to get the loan on your federal income tax return. Along with points you pay upfront, you can claim settlement costs such as bank fees, title search fees, processing fees and recording fees. The only catch is the fees must be prorated over the length of the loan. To figure the expenses you can deduct for the tax year, divide the total closing costs by the total number of monthly payments you will make on the loan. Multiply that amount by the number of payments you made for the year.
Improvements to Rental Property
If you refinance the mortgage on a rental property to make major improvements, you may be able to fully deduct the amount of expenses related to the improvements in the year you take out the loan. For example, you refinance the mortgage for $200,000 and have $5,000 in closing costs. If you use $100,000 of the loan money to make improvements to the rental property, you can deduct half of the total closing costs, or $2,500 as expenses for the year.
References
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Amber Keefer has more than 25 years of experience working in the fields of human services and health care administration. Writing professionally since 1997, she has written articles covering business and finance, health, fitness, parenting and senior living issues for both print and online publications. Keefer holds a B.A. from Bloomsburg University of Pennsylvania and an M.B.A. in health care management from Baker College.