With many areas of the country still experiencing suppressed real estate markets, many houses and other buildings are selling at historically low prices. These pieces of real estate are often purchased by individuals as investment properties. One important aspect of owning a building as investment property is the benefit of the tax deductions related to the property. Often, the question arises – "Is building investment property, deductible interest?" That, along with real estate taxes, insurance, repairs, and all types of other expenditures which must be reported on the tax return in the proper year are discussed here.
Is Your Investment Property for Reselling or for Renting?
There are two main categories that the IRS uses to determine the tax reporting.:
- Property purchased for resale at a profit
This is for the building purchased as an investment property, to resell as is or to improve and then resell. It is not expected to be leased or rented.
- Property purchased to lease or rent
This property is purchased for the purpose of renting. It may need renovations, but will ultimately be leased or rented.
Once it is determined whether the building is held for a resale or for renting, the tax handling of the expenditures can be determined.
Investment Property Deductions
When determining what investment property interest and expenses are deductible, it will help to know the most common expenditures and/or tax deductions for investment properties are:
This includes the actual purchase price of the building, and most of the closing and settlement expenses, such as Realtor’s fees, surveys, deed preparation, points, loan origination fees, attorney fees, and appraisal fees. Prepaid interest and real property taxes are an exception and would be handled as explained below.
Whether the building investment property is purchased for holding and reselling or for leasing, the purchase costs are considered capital expenditures and are not able to be deducted as expenses. For an investment property that will be held and sold, these purchase costs will be deducted from the selling price to determine the taxable gain or loss on the building when the building is sold. For an investment property that will be rented, the purchase costs will be depreciated.
Major Improvements and Repairs
A new roof, a remodeled kitchen, a new bathroom, new drywall, or an addition would all be examples of major improvements.
A major repair would be a repair, such as a roof repair, exterior painting, or partial new electric wiring, that would be expected to last many years.
As with the purchase costs, major improvements and repairs are not deductible as an expense on the current tax return. They are considered part of the “basis” or total cost of the building. For an investment property building held for resale, these expenditures will be deducted when the building is sold. For investment property that is leased or rented, major improvements or repairs will be depreciated.
Mortgage Interest and Other Interest Costs
For a building investment property deductible interest can be a little complex. General guidelines are listed here, but you would be very wise to consult with a tax professional for specific advice on your property.
For most types of investment property, the interest paid while improving, building, or constructing the real property falls under the Uniform Capitalization Rules, IRS code section 263A which requires that the interest incurred during construction or improvement should be capitalized instead of currently deducted.
After completion of the building or improvement, the interest becomes deductible as it is paid. If the building is available for lease, the interest is deductible on the Schedule E, as a rental property expense.
If the building is being held for resale, the interest after completion of construction can be handled in one of two ways: It can be taken as an itemized deduction on Schedule A, or an election can be made to capitalize the interest and add it to the cost of the building, thus delaying the deduction until the building is sold. This election must be made with the tax return when you file. Reference IRS code section 266, or see your tax professional, for more details on making the election.
This election, called an election to capitalize carrying charges, can be very valuable if the taxpayer does not have enough other deductions to take itemized deductions, or if it is desired to match the deduction to a year of higher income.
Real Property Taxes
Real property taxes are treated the same as deductible interest for an investment property. (See more explanation under the interest section).
Insurance for the building investment property can also be treated the same as real property taxes and building investment property interest. (See more explanation under the interest section).
Is Building Investment Property Deductible Interest? Your Questions Answered – Continued
Rentals and Buildings Purchased for Resale – Other Deductible Expenditures
In addition to building investment property deductible interest and other carrying charges, there are a variety of tax-deductible expenses such as repairs, mileage and travel costs, professional services, and more. Let's look at how these may be handled on your tax return, keeping in mind that you should consider whether they should be treated as carrying charges if the property is for resale and not a rental property.
Maintenance and Minor Repairs
The costs to keep a building investment property in good repair, such as touch up painting, buffing and waxing floors, cleaning carpets, mowing, yard clean-up, and repairing a furnace, are deductible on Schedule E for rental properties and on Schedule A for properties held for resale.
Mileage and Travel Expenses
Mileage and travel expenses incurred during construction or improvement of the building investment property are part of the cost of the building construction or improvement and are not currently deducted.
After completion, mileage and travel expenses to visit the property, collect rent, pick up supplies, consult with a professional, or any other mileage directly related to managing or owning the property is deductible, either on Schedule E (rental property) or Schedule A (property for resale).
Legal and Professional Services
Legal and professional services, such as attorney fees, architect fees, realtor fees, property management services, and accounting fees incurred during construction or improvement of the building investment property are generally part of the cost of the building construction or improvement and are not currently deducted.
After completion of the construction, amounts paid for additional legal and professional services incurred are deductible, either on Schedule E (rental property) or Schedule A (property for resale). This would include property management services, homeowner association fees, accounting, legal, and monthly maintenance fees assessed for a condo or other real property association.
Advertising expenses directly related to the construction or improvement of a building are considered part of the cost of the construction or improvement. Otherwise, they are deductible on Schedule E (rental) or Schedule A (resale property).
Utilities directly related to the construction or improvement of a building are considered part of the cost of the construction or improvement. Otherwise, they are deductible on Schedule E (rental) or Schedule A (resale property)..
Office Supplies, Other Supplies
Office supplies are generally deducted as an expense on Schedule E (rental) or Schedule A (resale property). This would include paper, receipt books, notebooks, small equipment such as a calculator, and other supplies used in the office and for record keeping.
An investment property building held only for resale is not depreciated. Instead, the costs are accumulated and deducted when the property is sold.
An investment property building for rental or leasing is depreciated, beginning from the time the building is available and offered for rental, even if it is vacant. The depreciation life will generally be 27.5 years for residential rental property (such as a house or apartment) and 39 years for non-residential rental property (such as a warehouse or retail store). Depreciation will include all of the capitalized costs, with the exception of the cost of the land. Land is not depreciated, although improvements to the land, such as a parking lot, would be depreciated or amortized.
Labor and Contract Labor
Payments for labor to maintain or make minor repairs on an investment property is deductible as an expense on Schedule E (rental) or Schedule A (resale property).
An individual owner of an investment property may not deduct the value of his own labor, whether or not payment is actually made. (The exception would be if the property is titled in the name of a corporation, an LLC, or otherwise set up as a separate entity. This article is intended for individual owners of investment property.)
A 1099-Misc should be issued to any individual who is paid $600.00 for more for services if the investment property is a rental property. It may also be necessary to issue the 1099-MISC if the property is being improved for resale only.
Consult a Professional
As you can see, the tax laws for rental and investment properties and especially for building investment property deductible interest and other carrying charges, can be fairly complex. Even if you prepare your own return, you may be well advised to consult a tax professional.
This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.
CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties
- IRS Schedule A Form and Instructions– Itemized Deductions
- Tax Almanac – Internal Revenue Code Sec 266 – Carrying Charges
- Cornell University Law School US Code – US Code Title 26 … Sec 1016 Adjustments to Basis
- IRS Schedule E Form and Instructions – Supplemental Income and Loss
- Tax Almanac – Internal Revenue Code Sec 263A