Real estate investors have a huge variety of expenses in running their businesses, and these expenses are generally deductible under one of two systems. Some short-term expenses can be fully deducted in the year in which they occur. Expenses to acquire, renovate or improve durable assets, such as real estate, however, are classified as capital expenditures. With these expenses you don't generally deduct everything the first year, but spread the deductions out over time, in a process called "amortization."
To understand how real estate assets are taxed, you must understand cost basis. Your cost basis in a property is every dollar you have invested in the property, including acquisition and improvement costs, as well as labor costs associated with these improvements. Subtract any deductions you have taken for depreciation over the years. The result is your tax basis. Your equity in real estate properties grows free of federal taxes.
When you make an investment into an investment property, you must keep track of this investment over time, and keep careful records. You then take your tax deduction gradually, over the useful life of the property. For most residential property, the useful life for the building itself is assumed for tax purposes to be 25 years.
Claiming Amortization Deductions
To claim the tax benefits of amortized deductions, file an IRS Form 4562, which provides the IRS with an itemized listing of each of your capital assets for which you are claiming the deduction.
Special rules apply to deducting and amortizing the costs of starting up a new real estate investment business. The IRS allows you to elect to amortize many of the costs of establishing a new business. Because many businesses lose money in the first few years of operation, amortizing start-up costs, rather than deducting them in the first year, may allow you a greater net tax benefit because you don't lose the benefit the tax write-offs for your start-up costs in a year in which you have no net income. Instead, you can write off your expenditures against your income gradually, as you earn income.
Some investment real estate expenses are 100 deductible in the first year, including mortgage interest payments, property management fees, the costs of repairs and routine maintenance (but not improvements), the cost of advertising for tenants, and fees for tax preparation, legal fees and other professional advice.
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