Is The Purchase Price of Properties Deductible As An Expense?

Question

I'm considering joining into a partnership with a property manager/realtor to buy/sell/rent  property.  He wants to form an LLC, in which we are both officers.  I will provide all the funds to purchase and fix the properties, while he will manage the repairs, rentals, and finding of new purchase opportunities.  He has also laid out a schedule of percentage cuts for each of us.  Every month, he will prepare a detailed statement of expenses and income, and send me a check for the net amount of my share, which I presume is taxable income.  He says when my original investment is returned, then we split the rest equally.

So, my question:  Is the purchase price of the properties deductible as an expense?  Or how does that work?

For example, say I pay $50,000 to purchase a property and another $50,000 to fix it up.  So, my total investment is $100,000.  We rent it out, and then over the next 10 years, my gross share is $100,000, and thus I have recouped my initial investment.  Then we go to sell the property and it is now worth $200,000, which is split evenly, so we each get $100,000 from the sale.

So, presumably, I'm paying 1/3 taxes during the 10 years of rental income, and so I net about $66,000 during that period.  But at the very end, when we spit the profit from the sale, since my original investment was $100,000 and my share of the sale was $100,000, does that mean I don't owe any real estate or income tax for the sale, making my net return on the entire investment $66,000?

Appreciate any help in clarifying this.

Also, I'm looking for a good accountant who is well versed in handling personal income and real estate tax, so please contact me if you know one.  I live in Illinois, and the LLC will be formed in Wisconsin.

Dave Lion · Answer

Thanks so much for the helpful explanations and examples!  Much clearer now.

Steven Hamilton II · Answer

Depreciation is your Basis (amount you paid for it) minus land(land does depreciate)  divided by either 27.5 or 39 years.

27.5 years for residential

39 years for commercial property.

Nathan Patterson · Answer

@Chin P.

Thanks for the explanation, that really helps.

Chin P. · Answer

To simplify the concept, depreciation is just a question of whether you are allowed to take 100% of a cost as an expense today or whether you must take the expense allocated in some fashion over time.  Most costs in a business are allowed to be considered an expense immediately and you get to take an immediate deduction on that year's tax return.  Stuff like labor costs, office supplies, etc.

Some things the government and the accounting world has considered to have a useful life of multiple years and has required that you are only allowed to recognize that expense and take it as a deduction over that useful life.  Think as examples 27.5 years for buildings (40 years under MACRS), 5 or so for computers, 5-7 for cars (I'm going from memory so the years may be off) .   That estimated life may be different depending upon what you are doing, so don't fixate upon the number of years too much.

So in your example, that 50k purchase plus 50k fix up is not allowed to all be taken as a tax deduction in the year of purchase.  Rather, you have a $100k basis in the house and are only allowed to take 1/27.5th of the $100k as a depreciation expense each year.  Depreciation is the name for physical assets and amortization is the name for intangible assets like goodwill.  Hope this helps.

Dave Lion · Answer

Thanks much for the answers.

Depreciation ... I've never been able to wrap my head around that concept!  I'll have read up (again) on it.

Thanks again.

Ramon Jenkins · Answer

I would also suggest consulting with @Steven Hamilton II

Chris Soignier · Answer

Also, note that only buildings and improvements are depreciable; the land value is not.

Brian Burke · Answer

If you guys bought the property for $50K and put $50K of capital improvements into it, your total basis in the property is $100K.  If you sell it for $200K you have $100K of gain.  If you guys split the gain 50/50, you each have $50K of gain to report.

In the real world, you will also depreciate the basis and then recapture it upon sale which will result in less taxable income during the hold period and depreciation recapture in addition to capital gain upon sale.

Dan Schwartz · Answer

Generally, the purchase price is depreciated. The depreciation is deductible, but the purchase price is not. Expenses incurred in the operation of the rental are deductible.

Sounds like you are ceding a lot of control, knowledge, and responsibility to this partner. Get someone on your side quickly to represent your interests. A CPA could be a good start.

Good luck!