If you own an investment property, there are a variety of reasons why refinancing could be a smart move for you. Just to name a few of the possibilities:
- Mortgage rates are at historically low levels, so if you have an existing higher-interest loan, refinancing could save you considerable money in the form of lower interest.
- Your investment property has gone up in value, and you want to take some cash out.
- You want to reduce (or increase) the time you're paying down the property.
Whatever the reason, tax treatment of investment property isn't well understood by many people. With that in mind, here's what you need to know about the potential effects of refinancing on your taxes.
Perhaps the most obvious change that comes with refinancing an investment property is the interest you'll be able to deduct. The IRS allows owners of investment property to deduct interest as an expense when calculating their net income on IRS Schedule E. By refinancing your property, the amount of this deduction may change.
As an example, let's say that you currently have a 30-year mortgage at 7% interest on an investment property you own, and that your original balance was $250,000 and you're five years into the loan. According to an amortization calculator, your remaining balance would be $235,038, and you'll pay $16,359 in interest over the next year.
If you refinance the remaining balance into a new 30-year loan with 4.5% interest, it could cut your interest expense for the next year to $10,499, a savings of $5,860. So, while you'll still likely be better off with the lower-interest mortgage, and theoretically the increased profit margin from your collected rent will make up for it, you're losing a significant portion of your interest deduction.
Financing costs must be amortized
When refinancing, the up-front costs of researching, drafting, and obtaining the loan are deductible, but not right away.
For an investment property, the cost of the property itself is considered a capital expense, and is depreciated, or spread out, over time on your taxes, instead of being deducted all at once. Similarly, up-front loan costs are also considered capital expenses, and are amortized over the life of the loan.
These expenses may include but are not limited to:
- Origination fees
- Up-front mortgage insurance premiums
- Application and credit report fees
- Appraisal fees (if required)
- Mortgage commissions
- Legal fees
- Title search fees
- Recording fees
For example, if it costs you a total of $6,000 to refinance a 15-year mortgage on an investment property, you can deduct $400 per year for the life of the loan.
Some items may be immediately deductible
There are some costs of refinancing that might be immediately deductible in full. For instance, if your old lender charges you a prepayment penalty, you can deduct the full amount of the penalty right away. Or, if you have any costs of getting the original loan (like those mentioned in the previous section) that you haven't already fully deducted, they can be immediately deducted when the original mortgage is paid off.
Are you ready to dive into investing? Check out The Motley Fool's Broker Center and get started today.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!