When you buy, sell, or refinance a home, closing costs are a major part of every transaction. Unfortunately, this can also be costly as many different mortgage fees and closing costs are required to transfer the home into your name. But what do closing costs include? Are taxes included in closing costs? Are any of these costs tax-deductible?
This guide will take a closer look at what is included in your closing costs and what may be considered deductible when it comes to tax time.
- Closing costs include third-party and lender charges, as well as statutory costs and taxes.
- Third-party costs include attorney fees, title search costs, real estate agent’s sales commission, and homeowner’s insurance.
- Lender charges can cover origination fees, inspections, land surveys, appraisals, and credit reports.
- Statutory costs and taxes can include transfer taxes, recording fees for deed, prorated taxes, and state and local fees.
- Loan points may be tax-deductible if certain conditions are met.
What happens at closing?
The purpose of the closing is to transfer ownership of the home to you. During this transfer, it is common to include the seller, real estate agent, your title or escrow company, and a variety of supportive office staff. During closing, you will go through and sign all the forms necessary to transfer ownership of the home. The title or escrow firm collects cashier’s checks for the closing costs and distributes the new keys to you upon completion.
What are closing costs?
Closing costs are essentially how third parties and lenders involved with the processing of a mortgage loan receive payment for their processing. On average, a buyer can expect to pay 3%-6% of their loan amount in closing costs. A few days prior, every buyer should receive a closing disclosure that itemizes all the fees included in the total closing costs.
Third-party closing costs
Third-party closing costs are expenses paid to outside companies and providers that assisted in selling the home.
- Attorney fees: Not all states require the use of attorneys. However, if an attorney is needed, they typically charge a percentage of the selling price but can work for hourly or flat fees.
- Title search costs: Your title company will arrange for a title search before the loan is completed to ensure no liens or lawsuits are involved with the property. They also verify that the seller is the current owner.
- Homeowners insurance: In many cases, your loan may require the first year’s premium of homeowner’s insurance to be paid up-front as part of your closing costs.
- Real estate agent’s sales commission: Real estate agents work for a commission on every property sold. This payment goes directly to the real estate agent.
Finance and lender charges
Finance and lender charges are assessed by your mortgage lender and can cover a wide range of fees and payments. These can vary based on your lender’s requirements but can include:
- Origination or application fees: These fees are for processing your mortgage. They may be a flat fee or a percentage of the loan value.
- Inspections: Inspection fees cover the required inspections necessary to approve your loan. These can include termite inspections or water tests to ensure a well and water system can maintain sufficient water supply to the purchased property.
- Points: A point equals 1% of the loan value and paying points can help you reduce your mortgage rate.
Document preparation fees: These fees cover the price of all the documents you will be signing during your closing.
- Land survey: Lenders often require a land survey to ensure that no one has encroached on the property. Land surveys are also done to verify buildings and determine improvements on the property.
- Appraisals: These costs cover the appraisal of your property that was used to establish value.
- Credit report: This is the cost of running the credit report required to approve you for your mortgage loan.
- Private Mortgage Insurance: Lenders often require PMI for buyers with a down payment less than 20%.
- Release fees: If the property has current liens against it and the seller has worked with the lien holder to acquire payment from the sale of the property, fees may be necessary to release the lien. In most cases, the seller pays this fee.
- Escrow account: Many lenders require that an escrow account is set up to cover taxes, homeowner’s insurance, and PMI if required. This money is collected monthly and used when these premiums are due.
- Prepaid interest: While your typical first mortgage payment is not due for six to eight weeks after closing, interest on your loan begins accruing immediately. Prepaid interest is the interest that will accrue between the closing date and your first mortgage payment.
Statutory costs and taxes
Statutory costs and tases are the fees collected by state and local agencies necessary for the sale of any property. These will vary by state and county and can include:
- Transfer taxes: This is a common fee required to transfer the title and deed from the seller to the buyer.
- Recording fees for deed: The county clerk typically collects this fee to record the deed transfer and adjust the property tax billing information to the new owner.
- Pro-rated taxes: Depending on when your sale takes place and when local taxes are collected, taxes such as school taxes and county taxes may need to be split between the buyer and seller depending on the occupancy percentage.
- Impound account: Similar to an escrow account, your lender may require an impound account to cover local taxes.
- State and local fees: Some state or local governments may require additional fees, such as a mortgage tax.
Are closing costs deductible?
Not all closing costs are deductible when filing your taxes for the year. However, those fees that are considered taxes or interest are.
The IRS considers points as a form of prepaid interest. These are tax-deductible if you meet these conditions:
- The mortgage covers your primary residence
- The mortgage is being used to make upgrades to your primary home
- Paying points is a normal business practice in your area, and you did not pay more than is customary
- You use the cash method of accounting
- The lender charged the normal amount for points
- The cash brought to closing was at least the amount of points charged by the lender
- The points were calculated as a percentage of the loan
- Your closing documents clearly shows how much you paid in points
Prepaid interest is the amount of interest paid to cover the period between closing and your first payment.
The state and local property taxes you pay are deductible in the year you pay them. The maximum a married couple can deduct is $10,000 ($5,000 for single) per year for property tax, sales tax, and state and local income tax combined.
The fees the lender charges to underwrite and process your loan, the IRS considers these fees the same as points, making them tax-deductible. These fees can even be deducted if the seller pays them.
Mortgage insurance premiums
The IRS considers four different types: private mortgage insurance (PMI), VA funding fees used for VA loans, USDA guarantee fees towards a USDA loan, and FHA up-front premiums used with FHA loans. This deduction is also dependent on certain income limits. You cannot claim this deduction once your adjusted gross income (AGI) exceeds $109,000.
Closing on your new home
As you can see, closing costs and taxes can cover a wide range of different fees and expenses. In fact, the average buyer will pay between 2-5% of their loan amount in closing costs.
At Hero Home Programs, we understand how intimidating the home closing process can be, and our team is here to help walk you through the process and ensure everything goes smoothly. Speak to us today to learn more.