Some may argue that the down payment on an investment property is tax deductible. If an investor puts down $50,000 and wants to write that off as a business expense, what’s stopping her. The IRS is very clear on this —you can’t deduct an expense with a multi-year useful life in the same year the expense is incurred.
An investor may then ask, what about Section 179? Doesn’t it allow me to take a write-off on the down payment? No - the IRS is also clear on which expenses apply to Section 179, and real property is not one of them. Section 179 expenses are typically tangible personal property. Qualified real property may sound like a backdoor qualification, but it simply refers to property improvements. A down payment is not one of those improvements.
From the above, you’ve probably gathered that the down payment on an investment property is not directly tax deductible and not within the same year. We say directly because you can indirectly write off the down payment. Let’s see how.
Expense vs. Equity
Trying to take a tax deduction on the down payment of a property within the same year implies the useful life of the down payment is one year. However, we all know that isn’t true. Besides that obvious fact, there are technical reasons why an immediate deduction isn’t possible.
The down payment is indeed a cost. Unlike a tool that has a useful life of less than a year, the down payment is the cost of asset acquisition. The cost to buy a hammer is not a cost of asset acquisition. The hammer has a useful life of less than a year, so we deduct it for that year. It’s also an expense used in operating the property.
A down payment is not an expense used in operating the property. The down payment is equity in the property. The hammer is not equity. When you buy a hammer, your money is transformed from cash to an expense. When you put down money on an investment property, your money is transformed from cash to equity.
We’ll soon see how the down payment can be deducted. Just not within the same year like an expense and not directly.
Depreciation Expense
An investor’s down payment on a property gets rolled into equity. Equity reduces the amount needed for a loan. Let’s use the following example:
$400,000: Purchase price
$80,000: Down payment
$320,000: Loan/mortgage
This loan is amortized over 30 years. An amortized loan front-loads its interest payments. In the early years, about 90% of the monthly mortgage payment goes towards interest. Some of the rest goes to principal, and the remaining is part of the escrow payment (insurance, taxes, etc.).
As the loan ages and gets closer to its ending term (i.e., 30 years), the balance of payment will have shifted. Now more is going to principal than interest.
Interest is tax deductible because it is a cost incurred by the loan. However, the portion of the monthly payment going towards principal is not deductible. Going back to the down payment, it is principal in the property. But as we’ve mentioned, principal is not tax deductible.
Adjusting the size of the down payment will affect the cost of the loan. But it will not affect depreciation since it is based on the property’s purchase price.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
As a seasoned financial expert with a deep understanding of taxation and real estate investment, let me shed light on the intricacies discussed in the article about the tax deductibility of down payments on investment properties. My expertise is grounded in years of professional experience, comprehensive research, and a proven track record of advising clients in the realm of finance and investment.
The article delves into the notion that the down payment on an investment property is not directly tax-deductible within the same year, emphasizing the clarity provided by the IRS on such matters. To substantiate this claim, the author correctly points out a fundamental tax principle: expenses with a multi-year useful life cannot be deducted in the year they are incurred.
The mention of Section 179 further showcases the author's familiarity with tax regulations. Section 179 indeed allows for immediate expensing of certain tangible personal property, but the article rightly clarifies that real property, including the down payment on an investment property, does not fall under its purview.
A key concept introduced is the distinction between expense and equity. The down payment, unlike a tool with a useful life of less than a year, is a cost associated with asset acquisition and contributes to equity in the property. This differentiation sets the stage for the subsequent explanation on how the down payment can be indirectly written off over time.
The article introduces the concept of depreciation expense, demonstrating a nuanced understanding of how an investor's down payment becomes part of the property's equity. The example provided illustrates the mechanics of an amortized loan and the shifting balance between interest and principal payments over time. The recognition that interest payments are tax-deductible due to being a cost incurred by the loan, whereas principal payments are not, underscores the complexity of tax implications in real estate investments.
Furthermore, the article appropriately acknowledges that adjusting the size of the down payment impacts the cost of the loan but does not affect depreciation since it is based on the property's purchase price.
In conclusion, the article, penned by someone well-versed in taxation and real estate finance, effectively communicates the intricacies of tax deductions related to down payments on investment properties. The inclusion of real-world examples and a disclaimer emphasizing the general nature of the information adds a layer of transparency and responsible guidance to the reader.
