When it comes to tax implications, closing costs can potentially play a role in reducing capital gains. By including your closing costs into the cost basis of your property when it's sold, you essentially increase the initial investment amount. The effect of this is that it reduces the total profit or 'capital gain' realized from the sale. As a result, the potential capital gains tax that you may owe to the IRS could be lessened. Here’s how it works.
Closing costs are expenses incurred on the transaction of a property. Both the seller and buyer pay these costs. Although the buyer typically pays less. Fees are generally between 6-10% for the seller and 2-5% for the buyer. The seller can deduct closing costs from the sale proceeds while the buyer has to pay them out of pocket.
There's no set price for closing costs. The total costs vary due to many factors, including state, home sale price, and the buyer's mortgage.
Since we are talking about capital gains, this article will focus on the seller's closing cost.
Closing costs are made up of the following, though this list is not all-inclusive:
Realtor commissions are by far the largest portion of closing costs for sellers. Negotiating on commissions can result in $1000s saved on higher-priced homes.
Closing costs are added to the home’s adjusted cost basis. This increases the cost basis, closing the gap to the selling price and thus reducing overall profit. Because profit is reduced, so are capital gains. So yes, closing costs can reduce capital gains.
If the property is sold for a loss, closing costs can still be added to the basis. In this case, it will increase the amount of loss.
Here’s how the math works on adding closing costs to the sale of property:
Sale price: $500,000
Adjust cost basis: $350,000
Total closing costs: $45,000
New basis: $395,000
Profit: $500,000 - $395,000 = $105,000
Capital gains on this sale will be $105,000, and taxes will be owed on this amount. You can see how adding the closing costs closed the gap to the sale price. Without the closing cost, taxable profits would have been $150,000.
When selling a rental, investors must also be aware of depreciation recapture. Depreciation recapture can't be added to the cost basis and is a tax owed to the IRS. If the home is sold for a loss, no depreciation recapture expense exists. This depreciation recapture, like capital gains taxes, can be deferred using a 1031 exchange to dispose of the property.