Tax Consequences of Investment Property

by Leslie McClintock

When you purchase real estate as an investment , rather than for your own personal use, you are subject to a new set of tax rules. While the principles remain the same, investment property is treated differently by the Internal Revenue Service under the tax code than real estate owned for personal use. To maximize potential profits, it is important to know the rules.

Capital Gains

The biggest tax disadvantage of investing in real estate is that investment property does not qualify for the $250,000 capital gains exclusion ($500,000 for married couples) that the IRS gives to those who own residential property.

Depreciation

The IRS realizes that buildings deteriorate over time, or become obsolete. For this reason, you can take a tax deduction to compensate you for the gradual unrealized loss in value for buildings machinery attached to your real estate investment. While investment properties can depreciate, personal real estate cannot be depreciated.

Mortgage-Related Deductions

While mortgage interest on your personal residence is deductible only if you don't fall under alternative minimum tax rules, the mortgage interest on investment properties is generally always deductible as a business expense. Primary mortgage insurance costs are also deductible for investment properties, as are points paid in lieu of interest. The cost of the property, however, is not deductible. Instead, property acquisition costs and fees associated are added to the cost basis of the property.

Passive Activity Rules

If you are collecting income from rent, you may fall under specific tax rules governing passive activities. Generally, passive activities are interests that generate income for you without requiring direct participation. Rent qualifies as a passive activity for those who are not professionals in the real-estate field. Passive activity rules restrict your ability to deduct losses against income from non-passive activities. For a full explanation of the rules, see IRS Publication 925.

Reporting

Miscellaneous Itemized Deductions, investment real estate expenses go on a Schedule C, Profit or Loss from Business. This helps the investor, because business deductions are not subject to a 2-percent threshold of annual income like individual itemized deductions are.

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