Closing costs associated with a mortgage loan (hereafter referred to as “loan costs”) can include various fees such as:

  • Appraisal fee
  • Credit report fee
  • Flood certification fee
  • Loan assumption fee
  • Loan processing fee
  • Mortgage recording fee (versus deed recording fee which is part of cost basis)
  • Tax service fee
  • Veterans affairs (VA) funding fee (applicable for VA loans)

Loan Costs vs. Cost Basis in Rental Properties

Loan costs are amortized over the term of the mortgage for rental properties. This means that the expenses are spread out over the life of the loan. When time flows, the expenses follow. When time elapses, the expenses vanish. If the property is not used for rental business during time span, the expenses for that period are essentially lost, as they cannot be carried forward or recovered. When the property used for rental business during the period, the prorated expenses are recognized.

In contrast, the cost basis of a property is capitalized, meaning it is “preserved” in the property’s value. The cost basis remains as long as the property exists. When the property is used in a rental business, the cost basis can be depreciated, allowing you to allocate a portion of the cost basis to offset rental income. However, once the property is sold, the portion of the cost basis that was used to offset rental income cannot be used to offset capital gains again, as you cannot eat your cake and have it too.

Even if you do not take depreciation deductions, the IRS treats the property as if it has been depreciated. This means that depreciation recapture rules will apply upon the sale of the property, and you will be required to account for depreciation that you could have taken, regardless of whether you actually did. That is, if “allowed”, “allowable” is deemed taken.

Amortization for Converted Rental Properties

When you buy a rental property and use it for business from the beginning to the end, amortizing the loan cost is straightforward: you start to amortize, or deduct the prorated loan cost, until the mortgage is paid off. However, when you initially buy a property for personal use and later convert it to rental use, the process requires additional steps.

First, compute the total loan cost and divide it by the term of the loan to determine the monthly expense. This amount remains constant throughout the loan term.

Next, calculate the remaining time period from the start of the rental period to the end of the loan term. Multiply this period by the monthly expense calculated in the first step to find the remaining loan cost to be amortized. Amortize this remaining amount over the remaining period.

The following spreadsheet demonstrates the process:

Start End Months Years Loan cost
06/08/2017 06/07/2047 360 30.0 1,649
03/01/2023 06/07/2047 291 24.3 1,333

It is that simple. Once you understand the concept, the algorithm is straightforward.