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Appraisal Fee Deduction
I am getting a cash out refinance mortgage on one of my rentals and will be using the cash to rehab another property to rent out. As I understand it, the appraisal fee and some other closing costs are not immediately deductible. Are they amortized over the course of the loan or do they get added to the property basis? Also, should I deduct them on the schedule E for the property with the mortgage or the one I will be renovating with the funds?
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Originally posted by Kyle Meyers:
This is true. A few of the costs may be deductible in the year of purchase, but most can not be.
When you look at the HUD-1 you will find several categories of expenses listed in the settlement charges.
In the section "Items payable in connection with the loan" you will points (loan origination fees) and other loan fees. Loan fees and points must be amortized over the life of the loan in the case of investment property.
There are items such as interest, property insurance, property taxes that could be able to be expensed immediately.
You will also find charges related to title, recording fees, assessments, transfer fees, surveys, etc that are suppose to be added into the basis of the property.
I'll preface this by saying I'm not an accountant - so at least this will bump this thread - I'm also curious as to the real answers by someone more knowledgeable.
It's my understanding that these fees are not added to the basis, they are ammortized over the loan term - much like prepaid interest. As to which property schedule to deduct them - great question. I would think it depends on which property is actually paying for it. Hopefully a pro can answer this.
Originally posted by Kyle Meyers:
This is true. A few of the costs may be deductible in the year of purchase, but most can not be.
When you look at the HUD-1 you will find several categories of expenses listed in the settlement charges.
In the section "Items payable in connection with the loan" you will points (loan origination fees) and other loan fees. Loan fees and points must be amortized over the life of the loan in the case of investment property.
There are items such as interest, property insurance, property taxes that could be able to be expensed immediately.
You will also find charges related to title, recording fees, assessments, transfer fees, surveys, etc that are suppose to be added into the basis of the property.
Thanks for the response Charles Perkins, which property would these be listed for on schedule E when I prepare my taxes?
When you take out a loan the expenses and costs are allocated to the property the proceeds are used on. In this case you are using the proceeds to rehab another property so the costs are associated with that property.
By the book, it should go with the property(s) where the funds are being spent. If you went out and borrowed on an unsecured basis to purchase a property, then there would be no question, right? This happens all the time ("pulling money out of property A to buy properties B and C, or make improvements to property D). I have no doubt that most investors just allocate it to the original property A, because it's easier to track. However, if you sit on the borrowed funds for awhile before buying the new property, supposedly the interest is not deductible at all during that period. Wonder how many investors follow that rule? Not many, I'd imagine.
David Beard, that is what the consensus seemed to be when I was researching this. You are supposed to track where the proceeds are spent and allocate it that way, with no deduction if you use the proceeds for personal use.
In this case, the loan amount will be about the same as the amount I paid for the purchase and improvements to the property which was done without financing. Can I use the proceeds to "pay myself back" from funding the original purchase and rehab? I know some investors buy distressed property and fix it up then pull cash out, is the interest on that cash out mortgage not deductible for the property?
Hey Kyle Meyers, the IRS does not technically allow "look back" for loan allocation, only "look ahead". The way it's written, if you don't finance the purchase/rehab on the front end, you forfeit the right to deduct interest on that property for any new refinance proceeds you get in the future on that property.
You have to look ahead to what the funds are spent on, and if this is more than one property, then you have to allocate it to the new properties (the interest as well as amortizing loan costs).
And you do not want to commingle any of these refi proceeds in with your personal accounts, keep the proceeds in your RE bank accounts until spent.
Now you tell me how many investors follow this, the ones that go out and buy/rehab for cash, rent it up, and get a cash-out loan to "pay themselves back". I'll bet 90% reflect that interest expense on that same property on their Sch. E. These days, this is how many/most investors operate when buying REOs and other distressed properties. Note that using a HML for purchase and rehab on the front end changes things completely, as the rate/term refi just replaces the HML loan (unless you get net cash out, then you still have to look forward to what that new cash is used for).
Maybe some of the members that deal with IRS auditors on a daily basis can add their $.02.
I have talked to a few professionals today to get more information on this.
1st Source: Tax professor and retired CPA and tax attorney. Said to deduct interest and costs on schedule E for the property securing the loan.
2nd Source: TurboTax adviser. Her advice was to receive the cash out into a designated bank account and from there make distributions to whichever investments the funds will be used for and deduct interest as other interest (not mortgage interest) on schedule E in proportion to how the proceeds are distributed. She also said she though you could probably deduct on schedule A if you use the proceeds for personal expenses so long as you do not have more than 1 personal mortgage.
3rd Source: Attorney. He is doing additional research before he commits to an answer, but is leaning towards the same approach as I got from the TurboTax adviser.
I also have a call in to another CPA and have a couple other people I will ask and post the responses here.
Your tax professor is emphatically wrong, this is all part of the IRS' "tracing rules", nasty stuff. Your Turbo Tax adviser is correct.
http://www.borelassociates.com/topics/Tracing%20Rules%20for%20Interest%20Deductions.pdf
http://www.taxalmanac.org/index.php/Treasury_Regulations,_Subchapter_A,_Sec._1.163-8T
If you're constantly plowing your money back into your business to grow it, this has little overall impact.
Someone on another forum suggested having a LOC secured by liquid assets at your bank, and you would tap the LOC to close the loan transaction, establishing an appropriate "acquisition
loan", then you could do a rate/term refinance out of that loan (paying it off on the HUD) and match the new loan to the property.
Kyle Meyers,
I didn't bother to chime in after Charles Perkins put his correct reply in.
The interest goes on the property for which the interest occurs. For example if you personally take out a heloc for a rental property, the heloc interest is taken on Schedule E, as would any origination fees that must be amortized. The appraisal fee must be amortized over the life of the loan.
I deal with the IRS every day. This is how they want things. They want to match income with expenses. Just because the loan is secured by another property does not mean that it is related to that property.
Yes can pay yourself back from the proceeds. It actually does not matter if this is what is done.
If you want a more detailed outlook on this don't hesitate to ask me and I'll go into further detail.
Don't make a mountain out of a molehill. Sometimes we make it more complicated than it is.
-Steven the Tax Guy
Your guide to IRS laws, rules and regulations.
Originally posted by Steven Hamilton II:
Yes can pay yourself back from the proceeds. It actually does not matter if this is what is done.
Steven Hamilton II, so if I put $50k into a property, then take $40k cash out with a mortgage I can put that in my personal bank account and deduct interest on schedule E since I am not taking out more than I invested?
Technically yes. the only issue that you may run into is if you pull out more than your basis in your personal residence; however, that is beyond the scope of this class.
You must also be careful of when you refinance and pull out more than your basis and sell the property that you will end up paying tax on money you already took out of the property.
-Steven the Tax Guy
Originally posted by Steven Hamilton II:
Steven, not to belabor this, but some of the statements you've made seem somewhat contradictory and are just not hanging together for me. In your quote above, I think you are stating that the interest expense should be allocated to the property that was purchased or improved with the loan proceeds, not the property that is securing the loan. Is this correct??
This is stated plain as day in the Nolo real estate tax guide, that you have to trace the proceeds of a loan and allocate the interest to the property being acquired or improved. There is also voluminous support for this found by searching the web, just as I did in a previous post. Except for personal residence interest, deductability is driven by the use of the funds, that seems to be the answer whenever I do a little research on the topic.
Please state clearly how this works, and by the way, thanks for your input on the site, I always find it helpful.
From the research I have done and the input of everyone on this forum topic, I think it is clear the interest is attributed to the use of the proceeds of the loan as described in IRS Publication 535.
The second question that is not as clearly answered in the IRS materials is whether the proceeds can be allocated to repaying your personal funds from a purchase and subsequent rehab. Many investors purchase properties for cash and later cash out via a mortgage on the property to recoup some or all of their original investment.
I have come to the conclusion, and I believe Steven Hamilton II agreed above, that the proceeds received, up to the amount of the initial investment, can be allocated to repayment of the investment and therefore the interest can be deducted on Schedule E.
While I can't find any IRS rules specifically stating this (nor any opposing) I think there is more support for this approach than there is for declaring it non-deductible.
Publication 535 states " Generally, mortgage interest paid or accrued on real estate you own legally or equitably is deductible." and "Certain expenses you pay to obtain a mortgage cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. If the property mortgaged is business or income-producing property, you can amortize the costs over the life of the mortgage. "
The instructions for Form 1040 Schedule E state "If you have a mortgage on your rental property, enter on line 12 the amount of interest you paid for 2011 to banks or other financial institutions."
Publication 527 states "You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally cannot be deducted as a rental expense. "
Example: An investment property is purchased for $50k in cash. Then the property is rehabbed for an additional $30k in cash. Two years later, a cash out mortgage is taken against the property for $100k. The $100k would be deposited into a separate bank account as recommended in the procedures in Publication 535. $80k would be allocated to the original, non-financed, investment and would be available for immediate personal or business use. The remaining $20k could be allocated to non-financed investment in another property, or could be used to invest in a new property. 80% of the interest would be recorded on the Schedule E for the investment property the mortgage is secured by, the other 20% of the interest would be recorded on the Schedule E for the property which the $20k is allocated to.
Kyle Meyers - Kyle, I think I'll just have to disagree with your position, though I appreciate your research. I find nothing but evidence to the contrary. There are numerous examples on the web just like the one attached below. I find no support for the idea of paying yourself back, up the amount of the initial investment, if you paid in cash (if you financed initially and are not just refinancing, that is completely different).
It all relates to whether the funds are being used for acquiring or improving rental property. In your example, you used cash as your source to acquire the property.
There are many citations just like this one out there. I don't find anything to the contrary.
http://www.lawrencetax.com/taxinfo.html
BTW, Steven will appreciate that the author of the above is an Enrolled Agent, and not a CPA.
David Beard, the acquisition indebtedness information in the link you provided does make it seem like the pay yourself back method may not be accepted by the IRS. I had actually read through that article before, but didn't catch that part of it since it was about primary residence mortgages. Since there is no clear answer as to whether or not it would be acceptable and I am taking this loan for the specific purpose of a remodeling project on another rental, I will not trace any of the proceeds allocation to paying myself back. Thanks for your help with this.