Deducting losses or capitalizing costs

Dear Tax Talk,
In 2007, because of a depressed real estate market, we anticipate a loss of up to $80,000 on the sale of lake property purchased in 2005 for renovation and resale (no rental or personal use). We have costs of improvements, property taxes, interest on construction loan, utilities, yard maintenance, insurance, legal advice and the usual selling costs.

Presumably, we have the option of capitalizing some of these costs and adding them to the cost basis or taking a deduction on Schedule A of Form 1040 in the year cost was incurred. Presumably, cost of improvements and certain selling costs would be capitalized, but do we have the option of deducting or capitalizing the others? (For example, interest on loan could be capitalized under IRC 263A or used as a deduction on Schedule A.)

Assuming we have the option of either approach for some of these costs, the question is whether we will have enough capital gain in succeeding years to carry over the loss from year to year. Again, assuming annual capital gain of roughly $10,000, would it be better to take deductions for costs incurred in 2006 and again for costs incurred in 2007, the year of anticipated sale?
— Roger

Dear Roger,
It seems like you’ve done some homework before coming to me. The costs of carrying a property under construction usually must be capitalized to the property, unless it is your home. Accordingly, the interest, carrying costs (utilities, maintenance, etc.) and improvements will become part of the cost of the property during the construction period. The taxes can be deducted on Schedule A or capitalized as well.

If you never put the property to business use such as rental, the loss will be considered a capital loss and will only be deducted against capital gains, as you point out. The amount of your loss will be increased as a result of the capitalized costs, most of which you don’t have a choice on capitalizing. Whether you’ll have sufficient gains in the future or whether that’ll be most beneficial depends on your circumstances. If all you’re offsetting is long-term capital gains, your tax savings will only be 15 percent.

If instead of immediately selling the property you offer it for rent, you can convert your capital loss to ordinary loss. In addition, you can deduct your ordinary and necessary expenses for managing, conserving or maintaining rental property from the time you make it available for rent, even though you do not have rental income. In order to qualify for ordinary loss treatment, you will need to have offered for rent or rented the unit for more than one year. This converts the property to Section 1231 property and the loss on its sale becomes ordinary. See Publication 544 for more information on Section 1231 property.

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