Under normal circumstances, the proceeds you receive in the form of a loan are not taxable to you as income. However, if the creditor forgives all or part of a loan, the IRS considers that to be income to you, or to your company if your corporation took out the loan. Meanwhile, loan expenses, such as interest rates, are generally deductible as an ordinary business expense on investment property, though not on your individual residence.
Loans for Construction of Your Personal Residence
If the construction loan is a home equity loan secured by your equity in your personal residence, you can normally deduct the interest on a construction loan of up to $1 million for a new home purchase, and $100,000 for home improvement projects on your tax return. If the loan is for work on your personal residence but is not secured by your residence, then the interest is not normally deductible.
Loans For Personally-Owned Investment Property
If the property in question is investment property rather than a personal residence, you should also file a Schedule E, Supplemental Income (and Loss) form, which is designed to account for rental income and real estate expenditures. If you own your rental property within an S corporation or LLC, which are flow-through entities (profits and losses are disregarded at the corporate level and "flow-through" to your personal income tax return), you may also need to file a Schedule C, Profit (or Loss) From Business.
Calculation of Basis
Your tax basis in a property is the sum total of every non-deductible dollar you spent for the purchase, renovation or improvement of the property that you did not deduct. It carries forward from year to year for up to 27.5 years in the case of residential property. If you take depreciation deductions, you subtract your depreciation deductions from your tax basis. When you sell the property (unless you elect a 1031 'like-kind' exchange of investment properties, which defers the tax), the IRS will assess capital gains taxes on any profits -- defined as your sale price, less your tax basis. When you take out a construction loan and you spend the money on the construction project, you add that amount to your tax basis immediately. The higher your tax basis, the lower your capital gain will be when you sell the property. Calculate your depreciation, if any, on Form 4562.
If the lender forgives the debt, or part of the debt, you will receive an IRS Form 1099-C from them, detailing the amount forgiven. If it's a corporate loan, you must declare the forgiven amount as income on your IRS Form 1162 (for C corporations) or 1162S (for S corporations and LLCs that have elected to receive S corporation tax treatment.) If it's an individual loan, you must declare the amount forgiven as income, though certain exceptions apply on personal residential property if the borrower is insolvent.
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