Loan Origination Costs

There is always a lot of confusion, even among tax pros, as to the proper ways to treat, for tax purposes, the costs to obtain a new mortgage.

The only time loan origination costs are fully deductible in one lump sum is when it is for the purchase of a primary residence.  With any refi on a primary residence or the refi or purchase of any other kind of property (including rentals), the loan costs must be amortized over the life of the loan.

There are different approaches to handling the amortization period.  Most people and IRS loving tax pros use the nominal life of the loan, such as 30 years, and deduct one-thirtieth of the cost each year, giving a very tiny deduction each year.  When the loan is paid off early, through another refi or a sale, whatever unamortized portion of the original costs are remaining can be deducted in full in that year.

My approach, which I have been using for well over 20 years, and has always been accepted by IRS, is to use the expected life of the loan.  It is very rare that anyone's mortgage lasts a full 30 years, so I use the length of time we think it will last.  Barring any special situation with the client (pending sale or new refi), I have been using five years as my standard expected life.  This allows us to deduct one-fifth of the costs each year.  If the loan actually lasts longer than that, there will be no amortization in the sixth and subsequent years.  In the 20 + years I have been doing it this way, there may have been one or two times when this has happened.  The five year life has generally been longer than needed.

In fact, whenever I have started working with a new client who had started amortizing loan costs over some ridiculously long life (30 years), I immediately switched them to the more realistic five years.  Again, IRS has never once disagreed with that move.

In subsequent years, after starting with a five year expected loan life, we can modify the remaining expected life if situations change, such as a pending sale or refi.

Amortization of loan fees, as well as final write-off of remaining costs, are to be shown under "Other Expenses" (Line  18) on the Schedule E for that rental.

For any loan that no longer exists, you must deduct the remaining loan costs in that year, regardless of the size.  IRS could disallow the amortization of those costs in future years after the loan no longer exists. If there are more than one loan to be amortized in a single year, it's a good idea to list them separately either on Line 18 or on a backup schedule for the Amortization expense. 
 

Regarding the other costs associated with obtaining a loan in addition to the points.

What I have always done is use a wide interpretation of "loan origination cost" by combining all of the fees related to obtaining the loan, including the points, appraisal, credit reports, title insurance and doc prep fees.  It's a loose interpretation that many other tax pros don't follow.   However, I have actually been able to convince IRS auditors to accept my rationale, on the few occasions that they looked at this item on returns I had prepared.  

The other, more conservative approach is to capitalize the additional non-points fees as part of the cost of the property. 

Direct expensing of them is not something that you can do.
 

This page was updated:
Sunday, January 29, 2012