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George Saenz, the Bankrate.com Tax Talk columnist Capitalizing costs to real property

Dear Tax Talk,
Rental property: Can I elect to not deduct annual interest and taxes, but to add them to the adjusted basis of the rental property when I sell? Our AGI is over $150,000 and therefore the interest and taxes would only add to my loss carry forward that I cannot use to offset ordinary income in the current year.
-- Ed

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Dear Ed,
You're not losing anything by carrying forward your losses every year until you sell the property. In fact, capitalizing the cost to the property (i.e., adding it to the adjusted basis of the property) might lead to higher taxes when you sell.

When your AGI exceeds $150,000, you're not allowed to deduct rental real estate losses in excess of income from rental activities. Instead these losses carry over until a year that you have income from real estate, either net rental income or gains from sales, or if your AGI falls below the threshold. These carryover losses are considered ordinary losses, which reduce income taxed at higher rates.

If you capitalize the cost to rental property, you lose in a couple of ways. First, if you have a dip in income, you cannot take advantage of the losses carrying forward from rental real estate. The capitalized costs instead are only deducted when you sell that particular property.

Secondly, when you sell a rental property, your ordinary deductions (i.e., the carryover losses) will reduce income taxed at higher rates. If the costs were capitalized, they would reduce the long-term capital gain from the sale of that property, which is taxed at lower rates. The difference in tax rates could be as high as 20 percent, so if you capitalized $10,000 in costs you would lose out on $2,000 in tax savings. Hence, be satisfied carrying over your losses rather than capitalizing these costs.

Bankrate.com's corrections policy -- Posted: April 12, 2007
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