Treatment of refinance for rental properties

Technical topics regarding tax preparation.
#1
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I would like to know what should done for the refinance for rental properties. To make the issue for specific, I have the following simplified examples for the purpose to understanding the concept. What should be done for the loan cost, basis, and the credit when it is more than the total cost.

[1]
2000 Loan cost (Admin fee, Credit report, Title etc)
1000 Recording fees, Transfer tax, etc.
500 Escrow (insurance, HOA, etc)
(0) Lender credit

[2]
2000 Loan cost (Admin fee, Credit report, Title etc)
1000 Recording fees, Transfer tax, etc.
500 Escrow (insurance, HOA, etc)
(1500) Lender credit (less than loan cost)

[3]
2000 Loan cost (Admin fee, Credit report, Title etc)
1000 Recording fees, Transfer tax, etc.
500 Escrow (insurance, HOA, etc)
(2200) Lender credit (more than loan cost but less than loan cost and basis combined)

[4]
2000 Loan cost (Admin fee, Credit report, Title etc)
1000 Recording fees, Transfer tax, etc.
500 Escrow (insurance, HOA, etc)
(4300) Lender credit (more than loan cost and basis combined)
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#2
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The clarifications that I am seeking are:

1 - Whether or not the refinance loan cost for a rental property can be amortized over the length of the loan
2 - When there is a lender credit below the refinance loan cost, whether or not the refinance loan cost should be reduced
3 - When there is a lender credit that exceeds the refinance loan cost, how the credit should be treated
4 - Whether or not the cost basis that occurred in the refinance should be depreciated
5 - When there is a lender credit that exceeds the refinance loan cost, should the credit reduces the cost basis items
6 - When there is a lender credit that exceeds both the loan cost and expenses that are treated as cost basis, how the extra credit should be treated.

Thanks.
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#3
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Just practically speaking, where the lender credit reduces the costs of obtaining the refi loan, then this credit would reduce the amount of refinance fees to be amortized. In [1], [2] and [3], the amount to be amortized would be $3,500, $2,000 and $1,300, respectively.

Where the lender credit exceeds the costs of obtaining the refi loan, I would reduce the amount of the loan. In [4], the refi fees to be amortized would be zero, and the amount of the loan would be $800 less.

IMO, this is a practical solution because it reflects the economic realities. I don't have any research to offer.
 

#4
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NoCalCPA85 wrote:Just practically speaking, where the lender credit reduces the costs of obtaining the refi loan, then this credit would reduce the amount of refinance fees to be amortized. In [1], [2] and [3], the amount to be amortized would be $3,500, $2,000 and $1,300, respectively.

Where the lender credit exceeds the costs of obtaining the refi loan, I would reduce the amount of the loan. In [4], the refi fees to be amortized would be zero, and the amount of the loan would be $800 less.

IMO, this is a practical solution because it reflects the economic realities. I don't have any research to offer.

NoCalCPA85: Thanks for the reply! It makes sense but I have two follow up questions:

[1] "The government recording fees, Transfer tax, etc." are considered cost basis, not loan cost if this were initial purchase. For refinance, they are loan cost or basis? If it is cost basis, how your answers would differ?

Also the escrow costs (insurance, HOA dues, etc.) are neither loan cost nor basis, they are expenses when paid. They do not enter in any of the calculation. The only reason I put in the questions is to justify the lender credit, because that is the money a John Doe has to come out from his pocket, and a zero cost lender has to provide to complete the transaction.

[2] When you say "I would reduce the amount of the loan", you meant to reduce the amount of the loan interest, not principal, right? This is more reasonable and feasible as it is just one time adjustment on the interest deduction. The adjustment will depends the answer in [1].

Thanks again for the input.
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#5
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puravidatpt wrote:
NoCalCPA85 wrote:Just practically speaking, where the lender credit reduces the costs of obtaining the refi loan, then this credit would reduce the amount of refinance fees to be amortized. In [1], [2] and [3], the amount to be amortized would be $3,500, $2,000 and $1,300, respectively.

Where the lender credit exceeds the costs of obtaining the refi loan, I would reduce the amount of the loan. In [4], the refi fees to be amortized would be zero, and the amount of the loan would be $800 less.

IMO, this is a practical solution because it reflects the economic realities. I don't have any research to offer.

NoCalCPA85: Thanks for the reply! It makes sense but I have two follow up questions:

[1] "The government recording fees, Transfer tax, etc." are considered cost basis, not loan cost if this were initial purchase. For refinance, they are loan cost or basis? If it is cost basis, how your answers would differ?

Also the escrow costs (insurance, HOA dues, etc.) are neither loan cost nor basis, they are expenses when paid. They do not enter in any of the calculations. The only reason I put in the questions is to justify the lender credit, because that is the money a John Doe has to come out from his pocket, and a zero cost lender has to provide to complete the transaction.

[2] When you say "I would reduce the amount of the loan", you meant to reduce the amount of the loan interest, not principal, right? This is more reasonable and feasible as it is just one time adjustment on the interest deduction. The adjustment will depends the answer in [1].

Thanks again for the input.
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#6
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puravidatpt wrote:[1] "The government recording fees, Transfer tax, etc." are considered cost basis, not loan cost if this were initial purchase. For refinance, they are loan cost or basis? If it is cost basis, how your answers would differ?

If by "cost basis" you are referring to the cost basis of the property, then my answer is "loan cost." The only thing being acquired in a refinance in a loan, so the cost basis of the property is not affected.

puravidatpt wrote:Also the escrow costs (insurance, HOA dues, etc.) are neither loan cost nor basis, they are expenses when paid. They do not enter in any of the calculation.

If prorated insurance, HOA dues, etc. are being paid through the refinance, and if these are normal rental expenses, then yes, they are deductible as rental expenses.

puravidatpt wrote:[2] When you say "I would reduce the amount of the loan", you meant to reduce the amount of the loan interest, not principal, right? This is more reasonable and feasible as it is just one time adjustment on the interest deduction.

I meant that you would reduce the amount of the loan principal. Although I have no research on this, it just makes sense to me that if the owner of a rental is refinancing the loan and receives closing cost credits that exceed the loan costs charged, then the owner must be borrowing less principal. Why would you reduce interest when at the moment that the refi closes, no interest has accrued?
 

#7
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NoCalCPA85 wrote:If by "cost basis" you are referring to the cost basis of the property, then my answer is "loan cost." The only thing being acquired in a refinance in a loan, so the cost basis of the property is not affected.

I think it can be argued both ways. One way is as what you argued, "the only thing being acquired in a refinance in a loan", so all the costs are loan costs. The other way is that the loan cost proper are appraisal fee, credit report, etc. After spending for these items, we got an loan approval. It is just we have to go through the closing process in which there are other costs such as the government recording fees, transfer charges, etc. which are not directly connected with obtaining the loan. They are considered cost basis in initial purchases.

How do we determine which way is correct?

NoCalCPA85 wrote:I meant that you would reduce the amount of the loan principal. Although I have no research on this, it just makes sense to me that if the owner of a rental is refinancing the loan and receives closing cost credits that exceed the loan costs charged, then the owner must be borrowing less principal. Why would you reduce interest when at the moment that the refi closes, no interest has accrued?

How do we operate with "reducing the amount of the loan principal"? Suppose you get 1K net credit, and obtained 100K loan. You are saying the real loan amount is 99K, yeah, right, but the mortgage company reports interest based on 100K loan, what do you use as an interest deduction amount?

Because you get this credit, your true rental expense is reduced, so this is either an reduction in expense, or an increase in income, or reduction in the basis. How do we determine which way is correct?
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#8
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Isn’t there a de minimis rule for borrowings, where up to $5k can be expensed?
 

#9
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Never heard of that for a refinance.
 

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puravidatpt wrote:I think it can be argued both ways. One way is as what you argued, "the only thing being acquired in a refinance in a loan", so all the costs are loan costs. The other way is that the loan cost proper are appraisal fee, credit report, etc. After spending for these items, we got an loan approval. It is just we have to go through the closing process in which there are other costs such as the government recording fees, transfer charges, etc. which are not directly connected with obtaining the loan. They are considered cost basis in initial purchases.

I don’t think so. It’s well settled that the costs of obtaining a loan are capital expenditures that are amortized over the term of the loan.

puravidatpt wrote:How do we operate with "reducing the amount of the loan principal"? Suppose you get 1K net credit, and obtained 100K loan. You are saying the real loan amount is 99K, yeah, right, but the mortgage company reports interest based on 100K loan, what do you use as an interest deduction amount?

Because you get this credit, your true rental expense is reduced, so this is either an reduction in expense, or an increase in income, or reduction in the basis. How do we determine which way is correct?

I doubt that the excess credit results in income. Under that same theory, the proceeds from a cash-out refinance would result in income. By allowing the excess credit, the lender is giving an incentive to the borrower to make the loan. So, it must relate directly to the principal amount of the loan.

As an analogy, suppose I purchase real estate from a seller for $300,000. Closing costs are $3,000. The seller gives me a credit of $5,000 against closing costs. What do I do with the extra $2,000? The answer I believe is that I reduce the purchase price of the property to $298,000.

By the same token, if costs of a refi are $3,500 and the lender gives me a credit of $4,300 towards closing costs, the extra $800 must be applied against the loan principal. Consider it a payment towards the principal of the loan.
 

#11
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NoCalCPA85 wrote:I don’t think so. It’s well settled that the costs of obtaining a loan are capital expenditures that are amortized over the term of the loan.

I agree that the cost of obtaining a loan should be amortized, but the the government recording fees, transfer charges, etc. are not the cost of obtaining a loan, they are just the extra steps you need to complete after obtaining a loan. They are not a loan cost in initial purchase, do we agree on this? Why should refinance be different?

NoCalCPA85 wrote:As an analogy, suppose I purchase real estate from a seller for $300,000. Closing costs are $3,000. The seller gives me a credit of $5,000 against closing costs. What do I do with the extra $2,000? The answer I believe is that I reduce the purchase price of the property to $298,000.

By the same token, if costs of a refi are $3,500 and the lender gives me a credit of $4,300 towards closing costs, the extra $800 must be applied against the loan principal. Consider it a payment towards the principal of the loan.

I agree with the $298,000 example, and that is operational. You compute an amount based on $298,000 to for depreciation.

For the second example, you can apply the extra $800 against the loan principal in your own book, but the lender still uses their principal to charge your interest, not your principal. What do you do with the interest? The credit should be used to offset the interest, either one time or over the time, which is equivalent as an increase in income.

If a positive loan cost results in an expense over time ("amortization"), then a negative loan cost (credit) should result in a negative expense (income) over time, since it is in the favor the IRS, they would not object to allocate as one time income for simplicity on the part of the taxpayer.
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#12
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1.263(a)-5(a)(9); 1.263(a)-5(d)(3)
Last edited by HenryDavid on 25-Jul-2022 8:31pm, edited 1 time in total.
 

#13
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HenryDavid wrote:1.263(a)-5(a)(10)
is writing an option, but
HenryDavid wrote:1.263(a)-5(d)(3)
does have the $5,000 de minimis language. Thanks.
 

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Whoops, (9)
 

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HenryDavid and sjrcpa,

Thanks for your inputs. Let me see what I can take home from your inputs.

    1 - Suppose in a refinance, if the loan expenses (appraisal fee, credit report, etc) plus cost basis items (government recording, transfer charges) minus lender credit is less or equal $5,000, then we can deduct the cost as "refinance cost" currently?

    2 - There is no need to differentiate loan cost and cost basis items in above situation?

    3 - The prepaid items such as insurance, HOA dues do not enter in the $5,000 calculation (as they will be deducted elsewhere when paid)?
If all three are true, then this will cover most of the refinance situations. Questions remain are:

    4 - Does the de minimis rule apply to the less than $5,000 loan cost in an initial purchase of a rental property? Or we need to amortize it regardless of the amount?

    5 - How to handle the net credit when the lender credit exceeds the loan cost and cost basis items combined?
Thanks.
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#16
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5 - How to handle the net credit when the lender credit exceeds the loan cost and cost basis items combined?

Seems to me they lent you, say, $100,000, and you'll pay back the same principal. But they credited you an amount that, effectively, reduces the interest rate and should be amortized into income much the same as the out-of-pocket costs would be amortized into expense. That's essentially what OP said in the last sentence of #4 above.

It's not immediate income because the borrower did not receive anything; he just got a lower effective interest rate.

If I get a chance, I'll ask my CRD to find the authorities for my answer.

BTW, I have not re-read the foregoing posts, but to the extent you are netting charges against credits, I think that's wrong. Each gets its own treatment. For instance, maybe the amortization of the loan costs over the term of the loan is straight-line, while the amortization of the credit might be on a basis of the loan balance, i.e., an interest reduction.
 

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HenryDavid wrote:1.263(a)-5(a)(9); 1.263(a)-5(d)(3)

Are you sure that 1.263(a)-5(d)(3) allows you to write off loan costs of a refinance loan for rental property loan if the costs don’t exceed $5,000?

1.263(a)-5 is titled “Amounts paid or incurred to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions.”

1.263(a)-5(a)(9) says that “a borrowing” means “any issuance of debt, including an issuance of debt in an acquisition of capital or in a recapitalization.”

It appears to me that this reg. would apply only to an entity’s issuance of debt, such as when a corporation issues bonds. Are you sure that it can be applied to a loan obtained by an individual that is secured by rental property?
 

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“and certain other transactions”

“any issuance of debt”

Yes
 

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puravidatpt wrote:1 - Suppose in a refinance, if the loan expenses (appraisal fee, credit report, etc) plus cost basis items (government recording, transfer charges) minus lender credit is less or equal $5,000, then we can deduct the cost as "refinance cost" currently?

Not if the loan expenses are "paid" from the proceeds of the refi loan.
 

#20
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NoCalCPA85 wrote:
puravidatpt wrote:1 - Suppose in a refinance, if the loan expenses (appraisal fee, credit report, etc) plus cost basis items (government recording, transfer charges) minus lender credit is less or equal $5,000, then we can deduct the cost as "refinance cost" currently?

Not if the loan expenses are "paid" from the proceeds of the refi loan.

What you meant by "proceeds of the refi loan" is the same as "lender credit"? So if we "minus lender credit", the remainder can still be deducted, no? The scenario deals with the combined cost is more than the credit.
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