When dealing with investment property, the Internal Revenue Service looks at two basic kinds of expenses: maintenance and repair on the one hand, and renovation and improvement on the other. The two projects receive very different tax treatments. It's important for real estate investors to understand what category of project they are involved in, and to keep careful records, as the tax consequences of a remodeling can last for nearly three decades.
Repairs and Maintenance Versus Capital Expenditures
If you are doing a simple repair to restore a property to its normal functionality, the repairs are generally deductible in the year you incur them as ordinary business expenses. But if you are making any renovation or improvement that changes the function of a property, or is meant to improve the property value, you must "capitalize" the expenditure you incur. That means you cannot take the deduction all in one year, but you must spread the deduction out -- for up to 27.5 years, in the case of residential investment property. So repairing a broken door is generally tax deductible in the current year. But expenses associated with tearing out part of a wall and installing a new door must be amortized over time.
When you sell an investment property, the IRS will charge you capital gains tax on any profits you make, after accounting for your tax basis in the property. Your basis is the total of all expenses you paid for the purchase and improvement of the property for which you have not already taken a tax deduction. The higher your tax basis, the lower your capital gains tax liability when you sell the property (albeit the lower your theoretical profits, as well). Add the cost of any renovations or improvements you make, including labor costs, to your tax basis in the property.
Just as you depreciate the cost of rental property over time, you must also depreciate the cost of renovations, remodeling and improvements over time -- typically 27.5 years. However, certain appliances, such as stoves, refrigerators, and washers and dryers have a shorter expected life span, and therefore can be depreciated over a shorter time period. Depreciation is a form of tax deduction. Essentially, depreciation provides a way to account for the theoretical loss of value through fair use, wear and tear and obsolescence over time. You deduct the full cost of a rental house over 27.5 years.
To claim depreciation and to account for remodeling expenses on your individual tax return, file an IRS Form 4562 - Depreciation and Amortization, along with a Schedule E, Supplemental Income and Loss, and your Individual Form 1040. For specific information on how to calculate your depreciation and amortization on the property, see IRS Publication 946, How to Depreciate Property. Some types of investments may qualify for accelerated depreciation, which can lower your tax bill -- at least during the depreciation period. See, for example, Section 179 of the Internal Revenue Code, which allows property owners to take a large current-year deduction on certain purchases that would otherwise be capitalized over a period of years, in certain circumstances.
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