Our expensive investment-property tax mistake

My husband and I bought an investment property last fall. It's a one-bedroom condo in a building dating to 1915.

We bought the condo for $92,500 and put $35,000 down and about another $5,000 toward closing costs.

This isn't our first investment property, so we're familiar with how the IRS treats income from investment real estate.

On our existing investment property in New Jersey, we total the amount of rent we receive, subtract the amount we spend on it — a sum that includes mortgage payments, association payments, renovations and repairs, insurance, water, sewer, and one trip a year to inspect the place — and pay taxes on whatever is left over.

Some years, we take a loss.

Given all that, we thought that we could deduct the $35,000 down payment on our newly bought St. Paul, Minn., property as a business expense. Our ongoing mortgage payments are deductible, after all, so we figured that the chunk of money we tossed in at the beginning was also deductible.

We were wrong.

Or we were right, depending on how you think about it, but not in a way that will help us very much this year.

The $35,000 down payment is indeed a deductible business expense, but we can't deduct it all for the 2012 tax year. Instead, the rules require us to deduct that money over six years, a bit at a time.

We'll get our $35,000 deduction but can only use $5,840 of it in any given year.

That's fair enough, I suppose. And we'll probably appreciate it during tax years 2013 to 2018. In the meantime, though, it presents a bit of a problem.

My husband and I are self-employed, so we pay quarterly estimated taxes. Because we thought that we could deduct the full $35,000, I didn’t pay estimated taxes on the money I earned that we used for the down payment. (We filed for an income tax filing extension, so we didn't learn about this error until September.)

Because the estimated tax we paid fell substantially short of the full tax, we owe the IRS about $12,000 and the state of Minnesota about $4,000. That's a lot of money for us.

We also owe IRS penalties: 0.5% per month that the balance remains unpaid, as well as 3% annual interest on the amount due.

Minnesota gets 4% of the total owed, because we did not pay the amount due by April 15. Because we did pay that amount by Oct. 15, however, we can skip the additional 5% the state would charge on the unpaid amount.

We've paid Minnesota state taxes in full and are paying down our IRS bill. The IRS doesn't require that we make a formal payment plan unless we think it will take more than six months to pay them what we owe.

We think we can pay them off within six months.

If we meet with unexpected expenses that prevent us from paying the entire bill within that period, we can make a formal payment plan with the IRS at the end of that allotted time.

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I feel incredibly foolish, and that's a drag.

So is being out this much money all at once. But neither situation is the end of the world. No one will go without dinner, we don't have to sell the house and we won't be rocking burlap bags this fashion season.

Even so, we are tightening the purse strings for the time being, until the bill is paid and we have a financial cushion again. We are being more deliberate when we consider whether we need or want a potential purchase.

We'll likely still travel in the coming year, but within the United States and to visit friends and relatives who are willing to put us up. Restaurant meals will be fewer and farther between.

Most important of all, we'll be taking a break from guesses and assumptions when it comes to taxes. Instead, we'll be checking with an enrolled agent — the official term for a tax professional who passes muster with the IRS — before we do any more investing.

This was an expensive investment property tax mistake.