Deduct construction cost from personal income (for tax purpose)?

Question

Hello Biggerpockets community,

I am newbie in Real Estate. I just bought a house (in California) under my name using traditional bank loan (so no LLC or Corp). My thought process is that I will fix-up the house. If the market is good, I will sell it. If not, I can live in the house as I need a place to stay anyway.

If I sell the house, how can I deduct construction cost from my personal income? For example, my purchase price is $A, my construction cost is $B, and my sell price is $C. My personal income should be $C - ($A + $B), and I should be taxed on this profit. (and NOT $C - $A)

Since I don't have an LLC, the house is under my name, how can deduct $B from my personal income? It will be a misfortune if I can't deduct construction cost $B ...

I appreciate all of your input and advice since this is my first house ever!

Thank you very much,

Kathy L.

Katie L. · Answer

@Kathy L.

Congratulations!

Not enough information to totally know what you mean by "construction cost" if you mean major improvements or smaller repairs.  Also not clear if this is a rental property or your primary residence.  If it's an investment property, major improvements will get added to your basis, so no immediate deduction, but will get subtracted out upon sale which lowers your capital gain eventually upon sale (or increases your loss).  Minor repairs or improvements will be deducted immediately.  If it's your personal residence, only major improvements get added to your basis and current minor repairs are not deductible.  You'll also want to look at which costs from your selling expenses and escrow get added to basis, which get expensed, and which you have to eat (generally the ones having to do with the loan).  Get with a good CPA to discuss as you'll be happy when you sell that you know exactly what your basis is and kept good track of such information as the costs went out rather than trying to recalculate it years from now.

*None of this post creates an attorney-client or CPA-client relationship.  Readers are advised to seek professional advice and not rely on this information in any way.

Katie L. · Answer

@Kathy L.

Sure you can convert to be an investment property.  You'll have to live elsewhere of course unless you house hack and make it partial personal/partial rental.  You'll want to be sure you have the right kind of loan though - usually owner occupied loans have more favorable rates.  You'll also have to pay income taxes on the rental income that comes in.  You will need to treat it as an investment property if you're claiming it as such.  You can't just claim your personal residence as investment if it's not an investment property.  Also, note there could be depreciation recapture upon the sale of a rental, and you also will likely not qualify (or at least a portion won't qualify) for the exclusion of gain from sale of principal residence under IRC 121.  So not all the benefits are for rental: you'll lose out on at least some of the gain exclusion, you have to pay tax on the rental income at ordinary rates, and you may have depreciation recapture upon sale which is higher rate than regular capital gains taxes, and you'll probably pay more mortgage interest over the life of the loan.

*This post does not create an attorney-client or CPA-client relationship.  Readers are advised to seek professional advice and is not to be relied upon in any way.

Dave Foster · Answer

@Kathy L., Yep that is exactly who the 1031 is designed for by statute - the buy and hold investor.  Flip's where your primary intent is to resell don't work for 1031.

Kat N. · Answer

@Dave Foster: Thanks Dave! I reached out to a friend who is local investor, he has been flipping 100 houses (~10 houses / year). He actually never took advantage of 1031 because of the timing limitation and sometimes he needs to buy or sell houses fast.

My hunch tells me that 1031 exchange is more suitable to passive investor (e.g rental property) who has time to plan and to exchange the property. Of course, I am exploring 1031, but it is my initial thought. Love to hear from yours!

Best,

Kathy Le

Dave Foster · Answer

@Kathy L., The 1031 exchange can certainly be a very valuable tool to you.  But the lure of tax free $ if you move in and take advantage of sec 121 as @Katie Lepore, was saying is powerful as well.

To use a model where you move in and take advantage of 121 your pace will be slower.  And you're right there are some expenses that will not get accounted for to your advantage.  The trade off of course is tax free vs. tax deferred.

I'd hold up those potential disallowed expenses against the tax that is eliminated with a 121 sale.

If you're a high earning individual then the extra write offs of expenses and depreciation might tip the scales to investment/1031.  Either tool can be an awesome way to go.

Kat N. · Answer

@Katie Lepore: Thanks so much Katie!!! It is very useful. Sorry for the late reply as I was trying to close the house documents.

I think for this house, I will keep it as primary residence as that is how I get it financed. I will learn about 1031 exchange as it looks like it is a way to go for long-term.

Kat N. · Answer

@Katie Lepore: Thank you very much.

This should be my personal residence because this is how it is documented in the escrow and bank loan. To summarize:

Personal residence:

1. Major improvements - added to my basis

2. Minor improvements - not deductible

3. Purchase / sales expense - depends, some expenses can be added to basis, some are not deductible.

Investment properties:

- All major, minor, purchase/sales expense are deductible - some are long-term, some are immediate deductions

So it looks like personal residence is at disadvantage. Probably a dumb follow-up question, how can I declare my property as investment property? Can I convert from personal residence/property to investment property?

Thanks,

Kathy L.

Deduct construction cost from personal income (for tax purpose)?

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