Do I Have to Prorate My Real Estate Deductions?
There are a number of tax advantages to investing in real estate -- including deductions for depreciation, repair and improvements. However, the specific treatment the tax code affords each of them differs with the type of expenditure and whether the property is for personal use or purchased as an investment.
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Personal Residences
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The IRS does not allow you to deduct the purchase price of a personal residence from your income tax. But you can deduct any interest you pay thereafter, on mortgages of up to $1 million. The nature of the deduction forces you to prorate your deduction over the years, though your deduction will gradually decline as you pay down interest. Payments on principal are not deductible, nor are ordinary repairs except when you rent the property. You cannot deduct commissions, either, but you can deduct points paid on mortgages in lieu of higher interest. You cannot deduct for depreciation with personal residences. You can deduct property taxes if assessed uniformly across the jurisdiction. You cannot deduct special assessments.
Investment Property
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If you purchase property as an investment, you have more opportunities for deductions. However, in most cases, except for routine repairs and the expenses of administering a real estate business, you must prorate your deductions across the expected useful life of the property, in a process called "amortization." You can also gradually deduct for the slow decline in value for a property, in a process called "depreciation." You cannot depreciate land -- however, only buildings and capital equipment.
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Basis and Capital Gain
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Your "basis" in property is the sum total of every after-tax dollar you have invested in the property, minus the amount you have already deducted for amortization and depreciation. When you purchase a property, your purchase price is your tax basis in the property. Every time you make a capital investment in improving the property, you don't get to take an immediate deduction, necessarily. Instead, the cost is added to your basis. When you sell the property, the IRS deducts your total basis in the property from the purchase price. If there are profits left over, you pay capital gains tax on the difference. The higher your basis, the less your capital gain, and the lower your capital gains tax (all other things being equal).
Section 179
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Section 179 of the Internal Revenue Code provides for an exception to the usual rules that require you to prorate, or amortize, your deductions over the useful life of the property. It allows businesses to take an immediate tax deduction of up to $500,000 on property or capital equipment placed into service in a profit-making venture or for the purpose of making a profit. You cannot normally take a Section 179 deduction on the property or structure itself, but you can take a Section 179 deduction on capital equipment, machinery, etc., used to enhance its value.
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