The IRS allows real estate investors to offset rental income with closing costs, unlike buying a personal residence.
While some closing costs on investment property can be written off right away, others must be added to your property basis and expensed out as part of depreciation over time.
What Are Closing Costs?
Closing costs on an investment property are similar to what you would pay on an owner-occupied property, with a few important exceptions. Let’s begin with a quick review of the different types of closing costs to expect when you’re buying any type of real estate:
- Title fees, escrow fees, recording fees, and transfer taxes (depending on the state you’re buying in)
- Prepaids and impounds for items such as taxes and interest and HOA fees
- Loan fees such as application, origination, credit report, and underwriting
- Mortgage insurance if our down payment is less than 20%, or in many cases with an FHA mortgage or VA loan in the form of a funding fee
- Due diligence fees such as property appraisal, inspection, termite and pest inspection, and survey
- Third-party professional fees such as an attorney or financial advisor
Typical Buyer and Seller Closing Costs
Although every deal is different, buyers can expect to pay between 3% and 4% of the contract purchase price while seller closing costs are often 8% or more.
While who pays which fees can often be negotiated between buyer and seller, these are the most typical buyer and seller closing costs real estate investors can expect:
Buyer closing fees
- Escrow or earnest money deposit
- Loan fees such as origination, underwriting, credit report, and discount points
- Attorney fees
- Appraisal fee
- Property inspection fees
- Lender’s title insurance
- Title search fees
Seller closing fees
- Title insurance premium
- Home warranty
- Mortgage payoff of existing loan
- Recording and transfer fees, and transfer taxes
- Prorated credits to buyer
- Real estate agent commission for both sides of the transaction
Types of Closing Costs on Investment Property
Now let’s take a closer look at some of the closing costs on an investment property:
Financing fees
- Credit report fee: is assessed by many lenders for running your credit report and credit score.
- Appraisal: is performed by an independent third-party to verify that the property being purchased has a value equal to the contract purchase price if not more.
- Underwriting fee: compensates the lender for organizing and preparing the loan documents, and assessing the risk of making the loan.
- Discount points: are paid up-front to lower the interest rate on the loan, where each point is 1% of the loan amount and typically reduces the mortgage interest rate by 0.25%.
- Mortgage insurance: also known as PMI or private mortgage insurance, protects the lender against borrower default and is normally required when the down payment on a conventional loan is less than 20% or an FHA or VA loan is being used.
- Lender’s title insurance: protects the lender from loss if there is a defect in the property title that the title search does not discover.
- Prepaid interest: is an account that collects loan interest between the time the transaction closes and the first mortgage payment is due.
- Prorated taxes: can appear as either a credit to the seller and a debit (charge) to the buyer if the seller has prepaid for property past the close of escrow, or as a debit to the seller if property taxes are due but haven’t yet been paid during the time the seller owned the property.
- Payoff of existing loan: removes the seller’s lender lien so that the property can transfer free and clear to the buyer.
Property fees
- Property inspection: required by the lender to verify the condition of the property, with most cash buyers also performing an inspection as part of the normal due diligence process.
- Survey: verifies the lot lines of the land or lot the property sits on and is used to identify easements such as utilities or access and to discover any encroachments from neighboring properties such as fence or sidewalk built over the property line.
- Septic: inspection normally performed in rural areas to evaluate the septic system components, check for leaks, and test the drainfield surrounding the septic system.
- Home warranty: an annual policy that serves as a type of insurance to maintain major household systems and appliances.
- Real estate agent commission: while commissions are negotiable, most real estate agents charge a commission of between 5% and 6% of the sales price of the property.
- HOA transfer fee: collected by the homeowners association for transferring and creating an account for the new owner.
- Transfer tax: a fee imposed by many states on the transfer of title of real property, either as a small percentage of the new property value or as a fixed transfer fee.
Professional fees
- Attorney: used in some states to facilitate real estate closings, and by many real estate investors to review purchase contract terms and conditions, deeds, and other closing documents.
- Financial advisor: assists real estate investors with large rental property portfolios to help ensure that each property purchase enhances long-term financial goals.
Tenant-related fees
- Prorated rent: a charge to the seller and credit to the buyer for tenant rent collected by the seller past the close of escrow date.
- Security deposit: a charge to the seller and credit to the buyer to record the transfer of the tenant’s security deposit to the new owner.
- Vender invoice: a charge to the seller and credit to the buyer for any invoices due but not yet paid during the time the seller owned the property.
Escrow fees
- Earnest money deposit: appears as a credit to the buyer for the “good faith” deposit made when the purchase offer was accepted by the seller.
- Title search fee: charged for performing a title search that verifies the history of the need and recorded claims against the property.
- Recording: normally a fixed or per-page fee for issuing and recording the new deed with the county the property is located in.
- Title insurance premium: buyer purchases an insurance policy to protect the lender, while the seller purchases an insurance policy to protect the buyer, in case title issues and unrecorded claims of ownership arise after the close of escrow.
- Miscellaneous: includes fees for services such as a notary, document delivery, flood certification, or other processing fees.
How to Lower Closing Costs on Investment Property
Clearly there are a lot of fees, but first-time real estate investors are often surprised at how quickly closing costs on an investment property can add up.
Even on an average rental property priced at $100,000, buyers can expect to pay closing fees of about $4,000 with seller closing fees averaging $8,000 or more.
At Roofstock, we help lower closing costs for sellers by charging only a 3% commission on the purchase price (as compared to the traditional 5-6% agent commission).
Buyers pay a small transaction fee of 0.5% or $500, whichever is higher, but can save money by purchasing property on Roofstock since many listed homes are already rented so that cash flow begins the day escrow closes.
Seller concessions can also lower the buyer’s closing costs.
A seller concession occurs when the seller agrees to pay some or all of the buyer’s closing costs. Here are two examples of how a seller concession could work, based on a property purchase price of $100,000 and a seller concession of $3,000:
- Keep purchase price at $100,000 with seller giving the buyer a $3,000 credit at closing, which reduces the net sales price to $97,000 before seller closing costs.
- Increase purchase price to $103,000 with seller giving the buyer a $3,000 credit at closing, which keeps the net sales price for the seller the same, before any seller closing costs.
There are pros and cons to seller concessions.
For example, if the real estate market is entering a normal downward trend, a seller might use a concession to motivate the buyer. Alternatively, the seller may be rebalancing a portfolio.
In a case like this, he may be willing to offer a concession of a few thousand dollars when selling one property in order to purchase a rental property with a higher yield in a more affordable secondary market.
Other Ways to Lower Investment Property Closing Costs
There are a variety of ways both buyers and sellers can lower investment property closing costs:
- Always ask your escrow officer for an investor discount on title company fees
- Closing at the end of the month can reduce pro rata charges such as tenant rent prorations and prepaid interest
- Request that the new owner’s title insurance policy be “reissued” if the property changed hands within the last few years
- Ask your real estate agent to work with you on the sales commission, especially if you’re doing multiple transactions with the same agent
Can Closing Costs be Written Off?
Some closing costs on investment property can be written off or expensed out right away, other closing costs need to be added to the property basis and then included as part of your depreciation expense.
closing costs that can be expensed on your P&L include:
- Mortgage interest (including prepaids and monthly interest expense)
- Most real estate taxes
- Some mortgage points
Other closing costs must be added to your basis and then depreciated over a period of 27.5 years for residential rental property:
- Legal fees
- Real estate commissions
- Recording fees
- Surveys
- Title insurance
- Real estate sales commissions
The types of closing costs on an investment property that can be expensed out versus added to your basis and depreciated can and do change based on federal law. Because of changes to the tax code, it’s always a good idea to use a tax advisor to ensure you’re not missing any deductions and that they’re being treated correctly on your tax return.
Wrapping Up
Closing costs on investment property are a fact of business life, so you shouldn’t let these fees and expenses keep you from investing in real estate.
However, by understanding how closing costs work with rental property, you’ll be in a better position to negotiate the best deal possible to save money and boost your overall ROI.
