Deductible prepayment penalty?

Prepayment penalty as income-related expenses: when the redemption counts for tax purposes

Landlords who take out bank loans to finance their rental properties can generally deduct the associated interest as income-related expenses. But what happens if a loan is repaid early – for example, because the bank demands additional collateral or a property is sold?

A recent tax court ruling has clarified this issue: If a loan taken out to finance rented property is repaid early, the prepayment penalties and processing fees incurred can be taken into account as income-related expenses – provided that the economic connection to the rental remains.

The case at a glance

A married couple rented out several properties that they had financed with loans. In addition, another property was deposited as collateral, which they originally used themselves and later also rented out. After the sale of this collateral property, the bank demanded immediate repayment of the two outstanding loans. The consequence: high prepayment penalties. However, the tax office refused to deduct these costs.

The verdict: Economic context is decisive

The court ruled in favor of the taxpayers: The repayment of the loans was economically linked to the rented property – not to the security property sold. This was because the loans had never been taken out to finance the house sold. The prepayment penalties were therefore deductible in full as income-related expenses. The same applies to the processing fees incurred.

Conclusion for practice

Anyone who finances rented properties with loans and has to repay them early should check carefully whether there is a direct link to the property. If this economic connection exists, early repayment costs are also tax-deductible.

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