May we count our mortgage payoff in the closing costs for the sale of our rental property?

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No.

Try this with pen and paper.

The formula for calculating your cost basis on rental property is as follows:

* Purchase price

* + Purchase costs (title & escrow fees, real estate agent commissions, etc.)

* + Improvements (replacing the roof, new furnace, etc.)

* + Selling costs (title & escrow fees, real estate agent commissions, etc.)

* - Accumulated depreciation (as reported on your tax forms)

* = Cost Basis

And then calculating your profit or loss would be:

* Selling price

* - Cost Basis

* = Gain or Loss