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RHJ1951
New Member

Rental Real Estate LLC Startup Costs

My wife and I formed an LLC to hold a residential rental property.  The LLC was formed before the property was purchased.  We purchased the property in our names but immediately transferred title to the LLC.  We incurred startup costs to form the LLC.  Are these costs deductible business expenses (& if so, on which form)?  Or must they be capitalized and amortized (if so, on which form)?

7 Replies
Critter
Level 15

Rental Real Estate LLC Startup Costs

You are posting from the BUSINESS version ... did the LLC incorporate ?   Or are you filing this as a Partnership ? 

AmyC
Expert Alumni

Rental Real Estate LLC Startup Costs

An LLC is a legal entity, not a tax entity. Start up costs are amortizable. They may qualify for up to $5,000 as a deduction. The amortized expenses go on the same form as the depreciation. The program will ask you questions and move things to the right place.

 

without knowing which forms you are filing, I can't be more specific.

 

If you need more help, please reply and clarify with more information about the type of business you have in the eyes of the IRS. When you filed for your EIN, it told you the type of return the IRS was expecting. That may help you.

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RHJ1951
New Member

Rental Real Estate LLC Startup Costs

As I mentioned, the LLC was formed to own and operate a rental real estate business.  The LLC owns a single family house and is renting it to a tenant.  My impression is that startup costs for rental real estate are different than startup costs for a trade or business.  But I don't know how the difference plays out for handling LLC and related startup costs.

Thanks.

RHJ1951
New Member

Rental Real Estate LLC Startup Costs

As I mentioned, the LLC was formed to own and operate a rental real estate business.  The LLC owns a single family house and is renting it to a tenant.  My impression is that startup costs for rental real estate are different than startup costs for a trade or business.  But I don't know how the difference plays out for handling LLC and related startup costs.

Thanks.

Critter
Level 15

Rental Real Estate LLC Startup Costs

@RHJ1951

You never answered my original question ... An LLC is not a "tax" category so we need to know your business entity ...  did the LLC  incorporate and will file an 1120  or an 1120S?   Or is this a partnership filing a form 1065? 

 

Usually the cost to form the entity can be expensed  however the cost to buy the RE are capitalized.  

Carl
Level 15

Rental Real Estate LLC Startup Costs

First, understand that residential rental proeperty income is reported on SCH E *no* *matter* *what*. So if you're filing a 1065 Parntership return (which is exactly what you file for a multi-member LLC that has two or more owners) the rental income is *still* reported on SCH E as a physical part of that 1065 partnership return.

Now, your LLC start-up costs are deductible "AS" start-up costs. To clarify, startup costs are those cost incurred "before" the LLC was open for business. This has absolutely nothing to do with the rental property in any way, shape, form or fashion. So the LLC could have been open for business weeks before it acquired it's first property.Absolutely no costs associated with the rental can be classified as LLC startup costs. You already made it clear that the LLC was established "before" you even purchased the property.  One problem you're going to have since the only income producing thing the LLC has income from, is rental property. So you're LLC isn't going to have any "EARNED" income to claim those start-up costs against. All the LLC has is passive income.

Now the LLC can deduct a maximum of $5000 in start-up expenses the first year. Any amount over that is amortized (not capitalized) and deducted (not depreciated) over the next 15 years. SO without other sources of income for the LLC, you will just be carrying forward your startup costs every year, until you either sell the LLC or the LLC acquires some other form of "EARNED" income.

Then for the rental property, that presents it's own legal issues if you think for a minute that transferring it to an LLC (single or multi-member) will protect your personal assets. It won't.  Pay particular attention to the "additional info for rental property owners" below.

Rental Property Assets/Cleaning/Maintenance/Repairs Defined

Property Improvement.

Property improvements are expenses you incur that add value to the property. Expenses for this are entered in the Assets/Depreciation section and depreciated over time. Property improvements can be done at any time after your initial purchase of the property. It does not matter if it was your residence or a rental at the time of the improvement. It still adds value to the property.

To be classified as a property improvement, two criteria must be met:

1) The improvement must become "a material part of" the property. For example, remodeling the bathroom, new cabinets or appliances in the kitchen. New carpet. Replacing that old Central Air unit.

2) The improvement must add "real" value to the property. In other words, when  the property is appraised by a qualified, certified, licensed property appraiser, he will appraise it at a higher value, than he would have without the improvements.

Cleaning & Maintenance

Those expenses incurred to maintain the rental property and it's assets in the useable condition the property and/or asset was designed and intended for. Routine cleaning and maintenance expenses are only deductible if they are incurred while the property is classified as a rental. Cleaning and maintenance expenses incurred in the process of preparing the property for rent are not deductible.

Repair

Those expenses incurred to return the property or it's assets to the same useable condition they were in, prior to the event that caused the property or asset to be unusable. Repair expenses incurred are only deductible if incurred while the property is classified as a rental. Repair costs incurred in the process of preparing the property for rent are not deductible.

Additional clarifications: Painting a room does not qualify as a property improvement. While the paint does become “a material part of” the property, from the perspective of a property appraiser, it doesn’t add “real value” to the property.

However, when you do something like convert the garage into a 3rd bedroom for example, making a  2 bedroom house into a 3 bedroom house adds “real value”. Of course, when you convert the garage to a bedroom, you’re going to paint it. But you will include the cost of painting as a part of the property improvement – not an expense separate from it.

 

Additional Information For Rental Property Owners

Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Nothing could be farther from the truth.  If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. That “veil of protection” supposedly offered by an LLC is so thin, even a new first time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. In fact, legal firms give these cases to their new lawyers for confidence building, because it's an easy win for them on behalf of the tenant. There are other problems and issues with this too.

In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash on hand to pay for it in full, your LLC will never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you, that’s not going to happen.

When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a rental property produces “passive” income. What’s the difference?

Earned income is income which you have to do out and “do something” in order to earn it. This income is subject to regular income tax, and also an additional 15.3% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.

Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.

SO if you create an LLC for your rental property, there are two things that will NOT happen.
 - You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
 - You will not report one penny of rental income or one penny of rental expense on SCH C.

So in the end, you will be filing a zero income/expense SCH C with your personal tax return.

Now let’s say you decide to file the 8832 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on SCH E as a part of the 1120-S Corporate Return, and you will also report the K-1 on SCH E as a part of your personal tax return. But keep in mind that this is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 8832 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.

SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan.  Overall though, it’s still financially dumb to do this. Here’s why I say that.

When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time.  A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.

One mistake I see quite often is that when an owner converts their primary residence or 2nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case.  If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.

tagteam
Level 15

Rental Real Estate LLC Startup Costs

Note that partnerships (multi-member LLCs) and S corporations use Form 8825 (not Schedule E) to report income and deductible expenses from rental real estate activities.

 

See https://www.irs.gov/forms-pubs/about-form-8825

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