Most of us will purchase property during our lives but few of us understand closing costs and which closing costs are deductible on our income tax returns. When you are spending anywhere from 3% to 5% of the purchase price of the home it would be nice to know what you are paying for.
Closing Costs can be divided into three general distinctions. Mortgage company fees, title company fees, and pre-paid fees. Some of these fees are deductible, most are not. You should know which ones are deductible and what they are for.
Start with mortgage company fees. They can vary from region to region but there are a few basic fees you will see throughout the country. The first fee is the Origination fee charged by the mortgage company. This fee is normally 1% of the loan amount, not the purchase price. The Origination fee is deductible on your taxes as it is considered interest and what the mortgage company is paid to place the mortgage. The next big fee is the Discount Points, which are dependent upon the interest rate at the time the loan is completed. Discount points can be negotiated. For example, the discount points will be determined by the amount of interest you are willing to pay over the life of the loan. If the going interest rate is 3.5% at a cost of 1 point, you can negotiate by taking a higher interest rate say a 4% for 0 points. Technically speaking, you are choosing whether you want to pay your interest over the lifetime of the loan or part of it up front. This Discount fee is also deductible as it is considered interest. These are the only costs a mortgage company has that are deductible. Other costs you may see are a Document Prep Fee, which is charged by the mortgage company for processing the loan. You may also have an Underwriter’s Fee, which is charged to have your loan approved/not approved. You will have an appraisal fee, credit report fee, tax service fee which are required for approval. Depending on where you live, you may have a flood certificate and termite inspection fee.
Title Company fees are generally not deductible, unless buying a house to rent. They include the Escrow Fee, which is the fee charged by the title company to close your sale. The Alta or Title Insurance Policy insures the lender against title fraud or mistakes. The Owner’s Policy (paid by the seller), which insures the owner and buyer from title search mistakes or fraud. Recording fees and Postal Overnight Costs associated with closing.
The last cost associated with closing is not necessarily a cost but a pre collection of expenses you will have. They are called prepaid costs and include the following. Prepaid Interest which is dependent upon when you close. Interest is always paid in arrears, just like a monthly salary. If you close early in the month by the time your first payment is due you may owe almost a double payment. So they collect the daily interest you will owe for that month and when your first payment is due you only have the one month payment. Prepaid taxes work similarly. They collect the taxes for the portion of the month you will own the house. They will also collect up to 7 months of taxes so that they can be sure they have enough to pay when your tax bill comes in. All of these are tax deductible. What is not deductible are the Prepaid Hazard Insurance and the Mortgage Insurance Premium that they collect. Note that if you put 20% or more down you will not have to pay a Mortgage Insurance Premium.
All of these costs are important to be aware of when purchasing a home and considering your tax consequences. Many of the costs associated with the Title Company and the Mortgage Company are split between the buyer and the seller. It is always a good idea to consult your tax advisor when considering the tax implications of your purchase as buying rental property changes many of the above.
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