A prepayment penalty (Vorfälligkeitsentschädigung) is the fee that must be paid to the lender (e.g. the bank) when a loan is repaid early. The question arises how such a fee should be treated for tax purposes within the income from letting and leasing. This is illustrated by the following dispute before the Cologne Tax Court.
The Case
During the period in dispute, the claimant generated income from letting and leasing from three developed properties. One of these rental properties was acquired in the 2006 assessment period and financed by means of a loan from the claimant's bank. The property was sold in 2018 and the sale proceeds were intended to be used for the early repayment of the financing loan. For the early repayment of this loan, the bank charged a prepayment penalty, which in the case of the sold rental property was to be claimed as ongoing income-related expenses within the income from letting and leasing. In addition, the remaining balance was to be used to partially repay the loans on the other two rental properties, with the claimant treating this payment as anticipated income-related expenses in his income tax return.
Contrary to the taxpayer's intention, the tax office did not allow the deduction of these income-related expenses.
Cologne Tax Court Ruling: Prepayment Penalty Not an Income-Related Expense
In the above dispute, the Cologne Tax Court ruled in favour of the tax office (FG Köln, judgment of 19 October 2023, 11 K 1802/22) and therefore denied the deduction of the prepayment penalty as an income-related expense. The court based its decision on the fact that, due to the sale of the property, the prepayment penalty no longer constitutes an income-related expense of the ongoing letting and leasing activity, but is instead allocated to the disposal transaction.
If this disposal of real estate is taxable under § 23 Abs. 1 Nr. 1 EStG (e.g. sale within ten years, or not continuously used for one's own residential purposes, or not used for such purposes in the year of sale and the two preceding years), the prepayment penalty can be claimed as disposal costs when determining the gain from private disposal transactions. If, as in the case decided, the disposal of the property is not taxable under § 23 Abs. 1 Nr. 1 EStG, the prepayment penalty cannot be claimed as an income-related expense — neither as ongoing income-related expenses within the income from letting and leasing, nor as disposal costs when calculating the gain from private disposal transactions.
The declaration of the partial repayment of other loans as anticipated income-related expenses was likewise denied, as the taxpayer lacked both the intention and the evidence to support an immediate repayment of those loans with the surplus amount.
Frequently asked questions
Frequently asked questions
Is an early repayment penalty deductible as income-related expenses when selling a rented property?
No. According to the ruling of the Cologne Tax Court dated 19 October 2023 (11 K 1802/22), an early repayment penalty incurred upon the sale of a rental property is not deductible as ongoing income-related expenses under income from letting and leasing. Economically, the payment is no longer attributable to the ongoing rental activity but rather to the disposal. The required causal link with rental income is therefore missing.
When can a prepayment penalty be claimed as selling expenses?
If the sale of the property qualifies as a taxable private disposal under § 23 Abs. 1 Nr. 1 EStG (e.g., sale within the 10-year period without continuous owner-occupation), the prepayment penalty can be deducted as selling expenses when determining the gain. It thereby reduces the taxable capital gain from the disposal.
What happens to the prepayment penalty when a property sale is not taxable?
If the sale is not taxable under § 23 EStG (e.g., outside the 10-year holding period), the prepayment penalty is entirely lost for tax purposes. It can be deducted neither as income-related expenses from rental income nor as selling costs in private disposal transactions.
Can repaying other rental property loans with the sale proceeds qualify as anticipated income-related expenses?
In principle, redirecting the remaining sale proceeds to repay other rental property loans may be possible, but it requires demonstrable intent and actual prompt use of the funds. In the case at hand, the Tax Court of Cologne denied the deduction because there was no concrete evidence and no immediate intent to repay. Taxpayers should therefore allocate the funds promptly and document the process.
What is a prepayment penalty (Vorfälligkeitsentschädigung)?
A Vorfälligkeitsentschädigung is the compensation a borrower must pay to the lender when a loan is repaid before the end of the agreed fixed-interest period. It compensates the bank for the lost interest income and typically arises when a loan is repaid early in connection with the sale of a property.