This week, I wanted to take a closer look at real estate tax questions that begin with the phrase, “Can I deduct,” and then mention the cost of fixing or upgrading something in the house. Sometimes the writer mentions that it’s a personal residence, and other times the writer doesn’t specify whether the property is a personal residence, an investment property, or a mixed-use property.
It’s clear that we need to have a common ground to start from, and go back to the 101 level to make sure we define some terms. Looking at the questions that are coming from readers, confusion over what costs are legally deductible and what costs you cannot fully deduct in the current year is a common theme. So let’s get back to basics.
First of all, you cannot answer any question regarding how a property will be treated under the tax code without first classifying it. There are two sets of rules under the tax code: one set for personal residences and one set for investment properties. It is possible for properties to be mixed-use. For example, you can live in a home for part of the year and rent it out for tourist season. But most folks have one personal residence and any other properties they own are strictly investments.
If the property is for your own personal use, repair and renovation expenses are almost never deductible. Put it out of your mind. You can’t deduct repairs, and you can’t deduct renovations to a personal property. The IRS considers these to be personal expenses, and so they are normally covered under your standard deduction, which is the amount the IRS doesn’t tax so you can spend it on basic, bare-bones living expenses.
You also don’t claim depreciation on a personal residence – at least while you’re living there. Instead, you get the benefit of a capital gains tax exemption on the first $250,000 of gains (double that if you are married) when you sell the home – provided you meet the ownership and use tests. Special rules apply to military families.
There are always exceptions aren’t there? Here are the exceptions with personal property:
Home mortgage interest. Most people are familiar with this deduction. Currently, you can deduct interest paid on a mortgage secured by your own home up to $1 million, or for home equity loans (on a home you already own) up to $100,000.
Prepaid points. If you pay points in lieu of interest (that is, you “buy down” to a lower interest rate on a new mortgage by paying points), you can deduct this expense, but normally only gradually, over time, just as you would have claimed the deduction on a home mortgage.
Casualty losses. Unexpected casualty losses – fires, floods, burglaries, sinkholes, and the like – are normally deductible, even when the loss takes the form of the necessity of paying for repairs on a personal residence. You can only deduct the portion of damages for which you are not reimbursed by an insurance company. If they pay the damages, then the deduction for that part of the damages they pay goes to the insurance company, not to you. (Remember, it’s just a cost of doing business for them!) You report these losses on IRS Form 4684. Note that you have to deduct 10 percent of your adjusted gross income from your casualty losses before you can start deducting them against income. You also have to deduct $100 from each separate loss.
Note: Casualty losses have to be sudden and not something you can reasonably expect. Termite damage, for example, happens too gradually to qualify as a deductible expense. But see this information on deducting losses from corrosive drywall for your 2012 tax return or certain years prior to that. For more information, see IRS Publication 547.
Taxes. You can normally deduct property and other local taxes paid to local and state revenue agencies – provided they are uniformly assessed on properties throughout the jurisdiction. If it’s a special assessment for your own housing development, though, it’s not normally a federal tax deduction.
The rules with investment property are more liberal – but more complicated. Generally, you can deduct – in some way, shape or form – expenses you incur to acquire, maintain or improve investment property. But usually not all at once.
What kinds of things can you deduct now, all at once, in the current year?
Repairs. You can deduct the cost of routine maintenance and repairs to investment property in the year in which you incur the expense – but not the cost of anything smacking of renovation or improvement. The rule of thumb: Does it make the property useable? It’s probably a repair. Does it change the function of the property? It’s a renovation and not deductible in the current year. Does it materially increase the fair market value of the property? If so, it’s probably not a repair. You can’t deduct the cost in the year received. Instead, you have to recover the cost of your investment over time, through a process called depreciation and amortization.
Interest. You can generally deduct any interest you actually paid or incurred during the year on mortgages taken out on investment property.
Advertising and marketing. Had to advertise to get a tenant? You can deduct advertising and marketing expenses. That’s a cost of doing business.
Taxes. State and local taxes are deductible.
Travel and mileage. Had to travel to check on your properties? Attend meetings? Did you go to a real estate investors’ convention? You can generally deduct travel expenses attributable to running your real estate investment business. Generally, you can deduct mileage from your primary place of doing business (do you have a home office?) to your properties or any other business site. Specifically, effective Jan. 1 2013, you can deduct 56.5 cents for every mile you drive for business purposes.
Alternatively, you can deduct actual vehicle maintenance costs, but rules for this are complicated. Most folks just go with the mileage.
Note: You can only deduct 50 percent of meal and entertainment costs.
Legal and professional services. Here’s an important distinction: You can deduct the cost of tax planning, financial consulting and legal advice for your business, but not for yourself, personally (exception: Personal tax preparation costs are generally deductible). That means you can deduct the costs of attorneys’ fees involved in drawing up documents on your investment properties, but not on your personal residence.
Depreciation and amortization. When you buy any item with a useful life of over one year, for the purpose of earning money for you, you can’t normally deduct the cost in the first year (exception: Section 179 rules and business startup expenses). Instead, you have to spread your deductions over the expected useful life of the property.
For residential real estate, the IRS has defined that useful life of the property to be 27.5 years.
This means that if you spend $1,000,000 on an investment property, you do get to deduct the full cost of the property – but only a little at a time, over a period of 27.5 years.
Another word for this process is “capitalization.” That is, when you amortize the costs of an investment, you are “capitalizing” the costs of the investment over the useful life of the property.
There will be much more about each of these concepts in upcoming Tax Corner columns. But we’ll also refer back to this one occasionally, to keep ourselves grounded in the basics, and to give more novice real estate investors and homeowners something accessible to read up on the basics.