Pub 527 says don't include certain closing costs in basis?

Question

In publication 527 it says:

"The following are settlement fees and closing costs you can’t include in your basis in the property.

• Fire insurance premiums.
• Rent or other charges relating to occupancy of the property before closing.
• Charges connected with getting or refinancing a loan, such as:Points (discount points, loan origination fees),Mortgage insurance premiums,Loan assumption fees,Cost of a credit report, andFees for an appraisal required by a lender."
• Points (discount points, loan origination fees),
• Mortgage insurance premiums,
• Loan assumption fees,
• Cost of a credit report, and
• Fees for an appraisal required by a lender."

• Points (discount points, loan origination fees),
• Mortgage insurance premiums,
• Loan assumption fees,
• Cost of a credit report, and
• Fees for an appraisal required by a lender."

So, my question is, how do you account for these fees when doing your taxes?  They are clearly expenses that you have in purchasing a property for rent, and if you don't place the property in service right away (say you renovate for several months), I was under the impression you *were* supposed to add *all* costs to the basis and not expense them.

And what is "fire insurance premiums"?  In FL we have property insurance which covers liability, fire, wind, etc. Am I supposed to guess what percentage is for "fire"?

Michael Plaks · Answer

@Stuart M.

I'm sorry to hear that your income went to zero. I also apologize for assuming (from your post) that you were new and phrasing my response accordingly. The good part is: since you know the REI business, you will figure out how to make money under the new conditions. I know many people who already figured it out.

You are right to say that these seemed like easy questions. But they are not. So we gave you some starting pointers, but it's impossible to teach you our craft in a few online paragraphs. Just look at the size of the one publication you quoted. It's a lot to learn. Here on BP we share willingly when it is possible.

Since you're planning to do your taxes yourself, I recommend you cut corners and lump all these costs into the basis and then depreciate. It will not be technically accurate, but it will be close enough. All the best.

Eamonn McElroy · Answer

#2 is prorated rent revenue.  The closing statement prorates rent (based on ownership during the first partial month).  You'll usually see it when an investor sells a rental to another investor.  It's not uncommon.

If it is rent revenue already collected by the seller that is allocable to you, it is revenue to you.

If it is rent revenue to be collected by you in the future that is allocable to the seller, it is a current asset on your balance sheet which will offset (i.e. decrease)rent revenue when eventually collected.

Michael Plaks · Answer

@Stuart M.

Tax law is mostly grey, not black and white.

All purchase cost plus all rehab costs go into basis and begin depreciation when placed in service.

Taxes, in an opinion of at least one of my colleagues, are deductible even during the rehab. I think they go into basis.

All loan cost are amortized over the life of the loan. When amortization starts is debatable. Some say on the day of closing, I say on the day the underlying property is placed in service.

Another debatable item: if rehab financing was short-term, what happens to the cost of obtaining the short-term loan. Does it go into basis or becomes deductible at refi. Opinions differ on this one.

It is also debatable whether the interest during rehab is deductible or must stay in the basis.

If you want to simplify the tax code - everyone would be happy. Until then, we deal with grey area.

Stuart M. · Answer

@Michael Plaks

Would appreciate your response, as we do not have a closure

Stuart M. · Answer

Circling back around to this, it turns out I do not in fact like to cut corners nor do something that is not technically accurate not do something close enough. What would the "technically accurate" solution to this be?  Again its weird to me that these common issues (buy a property in 2018, put in service in 2019, how do you deal with PMI in the technical, accurate way, when the IRS says don't add it to the basis) don't have an answer agreed upon and instead people rely on inaccurate, technically incorrect maneuvers instead.  This has to apply to thousands, if not millions of rental properties a year!

(Is the answer, amortize them on the 4562 over the life of the loan starting in the latter year when the property is placed in service)

Stuart M. · Answer

LOL this seemed like an easy questions considering the only two conditions for properties are "ready to be placed in service" or "not ready to be placed in service" so this obviously has been determined millions of times before, weird there is no agreed upon answer.

BTW if you get "special" (construction is what they call it) insurance during that period, it would get paid at the same time and cover many of the same perils and liabilities (including fire).

BTW other than "hard money" there are "construction/rehab loans" which are conforming and backed by at least Fannie.

Anyways, our income has gone to zero (unlike those who don't take this seriously), rent and mortgage are due on the first, and I'm just trying to get our return done and get a refund, but let me go hire a CPA, thank you for your help.

Maybe you could offer to take on my case gratis in these trying times?

Michael Plaks · Answer

The publication and our responses assumed buying a rent-ready property. Here you start getting into the inevitable complexities, and we can't give you a comprehensive lesson online. This is what you hire your own tax accountant for.

You're right, all costs during the initial rehab should generally go into basis and are not immediately deductible. By the way, you should be using a special insurance for the rehab period, not the regular insurance which is for the occupied properties. And tax treatment of loan costs on the rehab funding, which is usually hard money, is controversial. Sorry, cannot give you a more specific advice in an online post.

Michael Plaks · Answer

@Stuart M.  This is a perfect explanation assuming that this is what the IRS meant by their clumsy wording "Rent or other charges relating to occupancy of the property before closing."  Notice that it is listed under costs, as opposed to credits. Prorated rent received from the seller is common, but it is a credit, not cost.

Stuart M. · Answer

Thank you, I guess I should have deleted point 2 because that's the one point that didn't apply to my situation, 1 and 3 are the ones I'm confused about because they make no sense.

Stuart M. · Answer

Can you help me understand how this translates to pen on paper?

#1, you say is a deductible expense.  I was under the impression that you could not deduct expenses until the property was placed in service.  Say you purchase "fire insurance" the day you close on a property, but then you renovate for 6 months, then you place the property in service.  On what form/line would you put "fire insurance" (and is "fire insurance" what the rest of us call property insurance that covers all perils)?

#3, you say you amortize over the length of the loan, so i take that as dividing it over 30 years if that's you loan and then expensing it over that 30 years, but A) again, what happens if you renovate for the first 6 months of your loan and the property isn't in service and you're not allowed to add the first 6 months worth to basis, and B) again, what form/line would this go on?

Pub 527 says don't include certain closing costs in basis?

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