There are often good reasons to refinance a rental property. If your equity in the property has increased, you may want to access some of the cash available to leverage by investing in additional assets. Or, perhaps interest rates have declined (or your credit has improved) and you can refinance at a lower cost. Another possibility is to change the length of the loan term. Whatever your reason is, investigate carefully before deciding.
What are the Closing Costs?
When you refinance (whether a personal residence or an investment property), there are costs involved. The closing costs are expenses that the owner pays to complete the transaction. When buying a property, some closing costs are paid by the seller and some by the buyer, but in a refinance transaction there is no seller. Closing costs often include loan origination fees (sometimes called points), appraisal fees, title charges, survey costs, recording fees, and taxes.
Which ones are Deductible?
Most closing costs for the refinance of an investment property are not deductible. The mortgage interest and property taxes can be deducted, but the rest are added to the cost basis for the asset and are depreciated. Depreciation in this context refers to the investor’s ability to deduct the cost of an asset over the course of its usable lifetime. The IRS allows residential rental property (buildings only, not land, which does not get “used up”) to be depreciated over a period of 27.5 years. If you are depreciating commercial property, the timeline is 39 years.
For example, if you have a rental property with a cost basis of $100,000, and $10,000 of that value is attributable to the land, the remaining $90,000 is depreciated by dividing it by 27.5. Each year, the property depreciation allowance is $3,272.72.
What changes the Cost Basis?
The basis of a property can be adjusted by closing costs and other acquisition expenses (and also by improvements.) The refinance costs noted above are added to the cost basis and included in the depreciation. If you take that same $100,000 value property (and again subtract the $10,000 for the value of the land for a cost basis of $90,000) and add $5,000 in refinance closing costs, the new cost basis is $95,000, beginning in the tax year that you complete the refinance and incur the costs.
How do adjustments to the cost basis impact depreciation recapture?
In simple terms, depreciation recapture is the process by which the money you have saved through depreciation lowers your cost basis in the IRS’ view, with the result that when you sell the property, your capital gain will appear higher. Here is an example:
If you have an asset with a cost basis of $250,000 and you have taken $40,000 in depreciation while owning it (and made no capital improvements or taken other actions to increase the cost basis), your adjusted cost basis according to the IRS is $210,000. If you sell the rental property for $350,000, your taxable gain will be $140,000 instead of $100,000. That is depreciation recapture, since you used depreciation to benefit from the aging of the property while it was appreciating.