Tax Strategies for Buying and Selling Property
Individuals own residential property for a variety of reasons, including their own residence, vacation home, and/or income rental property. To benefit fully from residential property investments, you must understand the tax laws affecting residential property that can enhance the return on your capital investment.
First, when one purchases real estate, the first concept every investor or home owner must understand is the concept of property "basis". When you are purchasing property, the only concept you are concerned about is how much you paid for it. However, over the years, you will continue to invest money into your home or investment property, such as a new kitchen, finished basement, a new driveway and so forth. Although these expenses are not deductible, they are added to the base cost of the purchase price. Therefore, your "basis" in the property has been increased by the amount of capital improvements made to the property.
Secondly, every real estate investor must understand the concept of depreciation. Depreciation is an expense written off over a period of time for the life of the asset acquired. In real estate, this period is usually between 27.5 years for residential rental property to 39 years for commercial real estate. Depreciation is deducted against the total basis of the property. For example, if you paid $300,000 for a 3-unit income property, invested an additional $10,000 in improvements, and have accumulated depreciation of $24,000 over a three year period, your basis in the property would be $286,000.
Basis is an important concept because it is this adjusted "basis" cost in the property that you must use when determining your gains or losses in the sale of the property. For example, lets say you decide to sell your three-flat property, which currently has a cost of $310,000 and an adjusted basis of $286,000. The sale price is $375,000. The gain on the sale would be $89,000, which is the sale price less the adjusted basis.
There are several methods used in determining the initial basis of real estate property. The closing statement generally is the best place to start to determine basis. Begin with the cost that often is referred to on the closing statement as the "gross amount due from buyer". Many settlement costs paid by the buyer are added to the basis, such as appraisals, credit reports, document and recording fees, title insurance and survey expenses. Several items on closing statements are not added to the property basis. These non-basis items include loan origination fees, apportioned real estate taxes, and flood insurance. These items are directly deducted in the year of purchase as a tax deduction.
There are more complicated rules affecting property basis when the property is donated as a gift, but generally the donor's basis carries over to the donee. This is true even if the fair market value was used to determine the amount of the gift for gift tax purposes. When property is inherited, then the property gets a basis of fair market value at the date of the decedent's death. For an exchange, the basis of the property given up is used to determine the basis of the new property received. Many times, when a principal residence is sold, the gain is "rolled over" into the new principal residence. The new personal residence's basis is first determined by looking at the buyer's closing statement and then reducing that amount by the deferred gain from the old residence. However, a taxpayer who has sold their home after May 6, 1997, is qualified to exclude all of the realized gain from the sale of the home, and is not required to report the sale on their return.
Capitalizable basis items are items which are added to the basis cost of the property. These items include capital improvements which have an asset life of longer than one year. These capital improvements differ from repairs and maintenance costs, which are deductible immediately. The rule of thumb in discriminating between capitalizable improvements versus repairs and maintenance are how these improvements affect the life of the asset, and costs associated with such improvements. Upkeep costs such as fixing leaks, filling cracks and holes in walls and minor replacement parts could easily be classified as repairs. A new roof, a new remodeled kitchen, or new electrical wiring would be considered a capitalizable improvement and depreciated accordingly.
In any real estate transaction, the burden of proof in determining the basis of any real estate property is upon the taxpayer. Therefore, accurate and contemporaneous record keeping is essential. It is not enough to just save your bills and contracts when owning your own property. You will need to provide information as to why the costs associated with your property were expensed as repairs and maintenance, rather than capitalized, if your return were to be audited. Keep a running log of improvements and repairs to your property. When the question of "property basis" ever arises, you will have the documentation and the knowledge to support your investment.