With long-term mortgage rates near historic lows, many owners of investment rental real estate are considering whether to refinance an existing property mortgage to help increase cash flow and profitability of the property. In addition to understanding the interest and principal repayment obligations of refinancing, owners should be aware of the tax implications of such refinancing.
Capitalized Financing Costs
When financing is obtained for a property, there are costs incurred with the due diligence, drafting, and approval of the loan that may not be immediately tax deductible. These costs include mortgage commissions, legal fees, title fees, and recording fees. Although paid immediately, these costs must be deducted over the life of the financing using a straight-line amortization methodology. Therefore, if $20,000 of non-deductible financing costs are paid to close a 10-year financing, these costs may be deducted $2,000 a year for 10 years.
Deduction for Existing Costs
While taxpayers are unable to immediately deduct the cost of capitalized financing costs incurred with a refinancing of a rental property, the refinancing can trigger the deduction of other costs. First, many lenders charge prepayment penalties to allow the borrower to repay a mortgage early, and to release the borrower from the obligations of the promissory note. These prepayment penalties are fully deductible at the time they are paid. In addition, any unamortized capitalized financing costs associated with the first mortgage can be immediately deducted when the first mortgage is satisfied. However, when refinancing with the same lender, this ability to deduct the unamortized capitalized financing costs can be limited.
Qualified Nonrecourse Financing
Individual taxpayers are typically limited in their ability to deduct losses generated by rental real estate. In general, taxpayers can't deduct losses greater than their combined basis in the real estate entity, and any recourse loans to the real estate entity. For example, a taxpayer making a $10,000 investment in real estate, and without any recourse loans to the real estate entity, would only be able to deduct the first $10,000 of any losses on the property. This is assuming no income is otherwise recognized by the taxpayer. Secured mortgage financing increases the amount of deductible loss that may be claimed by the taxpayer. Therefore, a taxpayer making a $10,000 investment in real property, with a $50,000 share of a secured mortgage financing, can deduct the first $60,000 of any losses on the property.
Debt Financed Distribution
Many investment real estate properties have fair market values that are greater than the underlying basis of the property. Investors might be tempted to use refinancing as a way to cash out of the property without selling it. For example, if a property originally cost $500,000, with $400,000 of lending institution financing, and the property now has a fair market value of $1 million, the investors might want to refinance for the full fair market value of the property, and pull the refinancing proceeds out of the business for their own purposes. While perfectly legal, the IRS prevents the investors from claiming a rental real estate interest deduction for any amounts of this distribution above the basis of the property.
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