When you buy real property, whether you're buying it to live in or as an investment, you're buying a tangible capital asset. To the Internal Revenue Service, this is a different process than buying a toaster or paying your cable television bill. When you undergo a capital expenditure, the money you spend comes back to impact your future taxes, both with personal and investment properties.
A capital expenditure is money that you spend to buy an asset that has a life that is longer than one year. The term "capital expenditure" is usually used in the world of business and investments, but the concept also comes into play with your personal residence. The IRS recognizes that a capital expenditure is an investment and remembers it. When you sell an asset, you subtract your capital expenditures to find your profit.
When you first buy real estate, your acquisition cost is more than your purchase price. The closing costs and other charges that you pay when you buy the house are all considered part of your initial capital expenditure. These include title fees, recording taxes and your closing attorney's fees. Loan costs, though, are excluded for residential properties.
Improving Your Property
While you own your property, you can continue making capital expenditures on it. Anything that you spend that isn't a repair and that either extends your property's life, increases its value or changes its use is probably going to be a capital expenditure. For instance, installing a sprinkler system in your lawn, adding a family room or completely renovating your kitchen are also capital expenditures. Replacing a broken window, fixing a leaky faucet or touching up interior paint, though, is a repair. Capital expenditures get added to your cost basis in your house.
Owning Investment Property
When you own investment property, the process of calculating your basis is roughly similar to calculating basis with your home, although you're able to add in some of the closing costs for your loan as well. However, while you own your property, you're allowed to depreciate some of your capital expenditures. The IRS lets you claim as a write-off a portion of the building's value and of any capital expenditures you make to improve it while you own it. This depreciation deduction simulates the gradual wearing out of the building. Your land, however, isn't depreciable; the IRS considers land to have an indefinite life.
Selling Your Property
When you sell your house, your gain is calculated by subtracting your adjusted basis from your net selling price after commissions and closing costs. For instance, if you bought your house for $250,000 and paid $6,250 in closing costs, your cost basis would be $256,250. If you put on a $18,000 roof and spent $50,000 on kitchen and bathroom remodels, you would add that $68,000 to the $256,250 to find your total adjusted basis of $324,250. If you sold it for $510,000 after closing costs and commissions, you'd have a profit of $185,750. When you sell investment property, your profit is calculated using the same method you use with a personal residence, except you must pay tax on any depreciation you claimed if you sell for more than its depreciated value. For instance, if you have an adjusted cost basis in your investment of $1,750,000 and you claimed $900,000 of depreciation while you owned it, your depreciated basis would be $850,000. If you sell for $1,350,000, you have a loss relative to your cost basis, but you're also selling for $500,000 more than your depreciated basis. That amount is subject to depreciation recapture tax.
- Complete Tax: What, Exactly, Is a Capital Expenditure?
- IRS: Publication 523
- Mark Minassian, CPA: Tax Deductible Closing Costs on an Investment Property
- IRS: Publication 527
- Exeter 1031 Exchange: Understanding Depreciation Recapture Income Tax Liability
- Nolo: Repairs vs. Improvements -- Complicated New Rules Go Into Effect in 2014
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