Q: I have a rental property I’ve owned for about 20 years. In the last year, I borrowed money on it three times, then paid it off. I had closing costs three times of approximately $3,500 each time. Now, I find that I have to add these costs to the “cost basis” of my rental house instead of being able to write it off. Why do I have to add this to my cost basis? What if I refinance every year? I’d like to use my property as a money bank, but this seems impossible.
A: First of all, I have to wonder why you refinanced your property three times in one year. That is an awfully expensive way to come up with cash.
Think about it, you spent more than $10,000 (3 x $3,500)
in closing costs in one year. You would have to generate an enormous return on that cash in order to justify that kind of expense, whether it is tax-deductible or not. You would probably be better off getting a home equity line of credit on your personal residence. The interest rate on owner-occupied property is lower than the rates for rental property and you would have to pay the closing costs only once. In fact, many banks and mortgage companies offer home equity loans with NO CLOSING COSTS. Since you tend to borrow large sums of money, then repay it quickly, you would benefit from an open line of credit that can be drawn upon at will — like spending money on a credit card — up to your maximum loan limit. The interest expense on a home equity credit line is deductible up to a maximum of $100,000 above the current balance of your first mortgage.
Before I answer your tax questions, please remember the usual disclaimer that I am not an accountant and this column is for general information only. Please seek professional tax advice. The tax deductibility of the closing costs and interest expense on loans secured by your rental property depends on what you do with the money. If you are using the cash to improve the rental property, buy more rental properties, invest in a business or purchase stocks, then the closing costs and interest expense would be a deductible business expense. But if you use the money for a consumer purchase, such buying as a car or boat for personal use, then the closing costs and interest expense are NOT tax-deductible. In other words, the fact that the loan is secured by a rental property does not automatically mean that the loan can be treated as a rental property business expense.
If the loan proceeds are used for a business purpose, the good news is that loan costs are tax-deductible, but the bad news is that those costs must be amortized over the life of the loan. For example, if you spend $3,500 in closing costs to get a new 30-year fixed rate loan, you can deduct 1/30th of the closing costs per year ($116.66/yr) until the loan is paid off. If the loan is paid off early, you can claim the unused balance of the closing costs as a tax deduction. For example, if you paid off the loan after only two years, you would have claimed $233.33 in tax deductions for the closing costs (2 x $116.66). You could then claim the remaining $3,266.67 balance of the closing costs as a deduction on that year’s income tax return.
In your case, you paid off the loans against your rental house in less than a year, so you would be able to deduct the entire total of $3,500 in closing costs on each loan during that tax year. But remember, those costs are deductible only if you used the loan proceeds for business or investment purposes. If not, then you cannot deduct any of the loan expenses on your income tax return.
As for adding the loan closing costs to the “cost basis” of your rental property, you apparently got some bad tax advice. The only time that the loan costs factor into the cost basis of a property is when you purchase it. They are considered part of your “acquisition costs.” After that, any refinancing costs you incur are irrelevant to your cost basis. Remember, the purpose of establishing your cost basis in a property is to determine how much you have to spend on a replacement property in order to accomplish a “tax-deferred exchange.” Under Section 1031 of the Internal Revenue Code, you can avoid paying income tax on your capital gains from the sale of a rental property as long as you buy a replacement investment property of equal or greater value within 180 days.
If you have questions about the tax consequences of buying or refinancing a piece of property, please consult an accountant BEFORE you finalize the deal. If you are puzzled by the advice you receive, get another opinion. More than once I’ve had my mortgage clients ask me about real estate tax advice they have received from an accountant that I know to be incorrect. The tax codes are very complicated. No one can be expected to be an expert on all areas of the tax system. Try to go to an accountant who specializes in real estate tax issues or at least spends a great deal of their time working in that area.