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jack73
Level 3

Calculating cost basis for rental property purchase with renovation

I purchased a rental property for $180,000 (let's just assume this number includes all the acquisition costs, but not the loan costs, which get amortized over length of the loan).  The total tax assessed value was $192,100 with $60,000 being the land portion.  It took 3 months for approximately $70,000 in renovations before being listed for rent.   For the initial cost basis, TurboTax appears to be calculating it as $180,000+70,000 ($250k) and then applying the ratio to get the improvement value, so the land value is calculated as $78,084 and improvements cost basis is $171,916.   Does it not make more sense to calculate the improvement value before renovations to show the true value of the land and improvements, and then apply the total renovation costs to the improvements?   In this scenario, the $180k purchase becomes a land value $56,221 and improvement value of $123,779, then add the $70,000 in building renovation costs, and the improvements cost basis is $193,779 for depreciation purposes, starting on date put into service.  Which is the correct method?

21 Replies
jack73
Level 3

Calculating cost basis for rental property purchase with renovation

@Carl  you seem to be the expert on this subject, but I couldn't find a post on this.

ColeenD3
Employee Tax Expert

Calculating cost basis for rental property purchase with renovation

Yes. Start with the purchase. Separate your land from your building. This will give you a percentage to use for any settlement fees, below.

 

Once you have that fixed, your improvement is added to the building portion. The land, unless there are specific improvements to it, will continue to be just the land.

 

Items added to basis.

 You can include in your basis the settlement fees and closing costs you paid for buying your home. A fee is for buying the home if you would have had to pay it even if you paid cash for the home. The following are some of the settlement fees and closing costs that you can include in the original basis of your home.

Abstract fees (abstract of title fees).

Charges for installing utility services.

Legal fees (including fees for the title search and preparation of the sales contract and deed).

Recording fees. Surveys. Transfer or stamp taxes.

Owner's title insurance.

Any amount the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, cost for improvements or repairs, and sales commissions. If the seller actually paid for any item for which you are liable and for which you can take a deduction (such as your share of the real estate taxes for the year of sale), you must reduce your basis by that amount unless you are charged for it in the settlement. Pub 530

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Carl
Level 15

Calculating cost basis for rental property purchase with renovation

Your land value is 31% of what you paid for it. Period. Renovations come in later.

So using your numbers (which are not spot on because sales expenses have not been tken into account yet, of course.)  when working through the asset you'll have something close to $180,000 in the COST box and $55,800 in the COST OF LAND box. The program will "do the math" in the background *for you* and will depreciate a structure value of $124,200 over the next 27.5 years.

Then you will click "Add An Asset" to add your property improvements which of course, will have *NO* land value, meaning you'll enter $70,000 in the COST box and a ZERO in the cost of land box. That full $70K will then be depreciated over 27.5 years.

So in the end because of the property improvements, your "land to structure" ratio won't be anywhere close to the 31% for land represented on your tax bill, and with your 70K of property improvements I wouldn't expect it to be either. In fact, I would question you as to "why?" with, after 70K of property improvements, your land value wasn't significantly "less" than 31% of the total cost basis.

Please note that the property tax values are only used by the program for establishing a somewhat realistic starting point. It's not like the IRS is going to check. But by doing it that way if you're ever pulled from one of those "random audits", you've at least got something to show the why and how you established the land/structure cost you used.

 

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

Thanks. @Carl you way is how I expected the program to work; however, it asks for purchase price, the tax assessor total valuation and land value, then asks for renovation costs, then it adds the renovation costs to your purchase price, then multiplies that by the tax assessor ratio, thus incorrectly increasing the land value and reducing the improvements value.

 

I'll use your method of not entering renovation costs on the supplied screen, and enter it later, to get the program to behave as expected. Its unfortunate that it doesn't calculate it correctly when you follow the walk-thru screens. 

Carl
Level 15

Calculating cost basis for rental property purchase with renovation

@jack73 I don't know what the reasoning was for having the program deal with improvements the way it does in the first year the property is placed in service. From a legal standpoint there's nothing really wrong with it. But from a technical/mathimatical standpoint it's wrong in my view.

There's also problems with the way some of the questions and selections are worded too. So if 2019 was your first year with this rental you have to be careful. The wording on some screens are "open to interpretation" by the reader. If  you interpret it wrong, then you'll have mistakes on SCH E in that first year that "WILL" grow exponentially as the years pass.

Then when you catch that error years down the road, the cost of fixing it will literally *eat* *your* *wallet* from the inside, out.

So I'm adding the below for you, as it provides the clarification that in my opinion (and we all know what opinions are like!) the program does not.

One common mistake that many rental owners make on their return in the first year they rent the property, is to report a personal use percentage of more than 0%. Even the experienced landlords do this, and it's because of the lack of clarity in the program combined with their "comfort level" from being an experienced landlord.

So check yourself with the below so  you don't end up getting bit later. 🙂

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence before, then this date is the day AFTER you moved out.
In Service Date - This is the date a renter "could" have moved in. Usually, this date is the day you put the FOR RENT sign in the front yard.
Number of days Rented - the day count for this starts from the first day a renter "could" have moved in. That should be your "in service" date if you were asked for that. Vacant periods between renters count also PROVIDED you did not live in the house for one single day during said period of vacancy.
Days of Personal Use - This number will be a big fat ZERO. Read the screen. It's asking for the number of days you lived in the property AFTER you converted it to a rental. I seriously doubt (though it is possible) that you lived in the house (or space, if renting a part of your home) as your primary residence or 2nd home, after you converted it to a rental.
Business Use Percentage. 100%. I'll put that in words so there's no doubt I didn't make a typo here. One Hundred Percent. After you converted this property or space to rental use, it was one hundred percent business use. What you used it for prior to the date of conversion doesn't count.

RENTAL PROPERTY ASSETS, MAINTENANCE/CLEANING/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.

 

 

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

@Carl  I really appreciate your answers. 

 

This property was never used for personal purposes, nor converted from my residence, so no questions there, I was just thrown off by TurboTax calculating things differently than I expected.

 

For everyone following along, any money spent on painting, cleaning, repairs, maintenance,  & utilities (normally expenses) between the time it is purchased and the time it is ready for rent (placed into service) is classified as part of the acquisition costs (improvements) and is depreciated, not deducted, correct?

 

If I replace the appliances during that time, I can enter those separately, so the are correctly depreciated over 5 years, instead of 27.5, right?   

 

For insurance, real estate taxes, and mortgage interest, do you have to prorate that between depreciation (for the time between purchase and put into service) and an expense (for time after it was put into service)?

 

For Loan Origination Fees, do they start at time of purchase or date the property was put into service?  

Carl
Level 15

Calculating cost basis for rental property purchase with renovation

any money spent on painting, cleaning, repairs, maintenance, & utilities (normally expenses) between the time it is purchased and the time it is ready for rent (placed into service) is classified as part of the acquisition costs (improvements) and is depreciated, not deducted, correct?

No. There is a difference between "acquiring" and "preparing". Cost associated with "acquiring" the property are added to the cost-basis and depreciated. Painting, cleaning, repairs, maintenance and utilities have nothing to do with acquisition of the property. Anything spent on "preparing" the property for rent after acquisition is just flat out not deductible. Period.

If I replace the appliances during that time, I can enter those separately, so the are correctly depreciated over 5 years, instead of 27.5, right?

You can. But I *highly* discourage it. With the exception of a hot water heater  and a built-in under-the-counter dishwasher, appliances such as stove, refrigerator, washer, etc. qualify for the safe harbor de-minimus if the cost is under $2,500. So you can just expense the replacements when that time comes. The cost will be under $2,500 too, because there's no way on this green earth that a landlord with at least one brain cell between their ears will put an appliance that costs more than that, in a rental property.

For insurance, real estate taxes, and mortgage interest, do you have to prorate that between depreciation (for the time between purchase and put into service) and an expense (for time after it was put into service)?

No. If between the date of purchase and the date place in service the property was not classified as your primary residence, 2nd home or vacation property, then it's 100% business use from the moment you signed the closing contract at the sale. For example, a property can be classified as residental rental real estate on the date you close on the purchase, but not place "in service" until say, 2 months after when you have it move in ready. So cost incurred between the closing date and the in service date "preparing the property for rent" are not deductible. Period. Just don't confuse those non-deductible "getting it ready to rent" costs, with property improvments. Two completely separate and unrelated things.

For Loan Origination Fees, do they start at time of purchase or date the property was put into service?

I can't remember. But those are loan acquisition costs, not property acquisition costs. Loan acquisition costs get amortized (not capitalized) and deducted (not depreciated) over the life of the loan. If done correctly the loan acquisition costs will appear as a separate line item on only the 4562 titled "Depreciation & Amortization Report" for that property.

Remember, capitalized/deprecated costs get recaptured and taxed when you sell the property. Whereas amortized/deducted cost are not recaptured. They are flat out deducted. So when you sell, any remaining amortization left to be deducted in the tax year you sell, get completed deducted in that tax year you sell.

 

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

"So cost incurred between the closing date and the in service date "preparing the property for rent" are not deductible. Period. Just don't confuse those non-deductible "getting it ready to rent" costs, with property improvments. Two completely separate and unrelated things."

 

If they are not deductible, aren't they depreciated?   If they are depreciated, are they not considered an "improvement"?  If they are neither, what are they and where are they tracked?

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

@Carl  This is where I got the idea that all expenses before placing a property into service had to be depreciated.  Not sure if it matters, but this is not my first rental properties, it just happens to be the first one that needed renovations before I listed it for rent.

 

https://www.therealestatecpa.com/blog/implement-barrrr-method-not-brrrr-method

 

"However, all expenses incurred BEFORE the property is placed in service, no matter what the expense is, NEEDS to be included in the cost basis of the property, capitalized and depreciated, which takes anywhere from 5 years to 27.5 years (for residential rental property) to recognize those deductions on the tax return. "

 

 

 

Carl
Level 15

Calculating cost basis for rental property purchase with renovation

I'm not making this stuff up out of thin air. The IRS has clear rules on this. Actually, the rules aren't exactly what I would call "clear". We are talking about the IRS after all. But here's what I was able to put together from numerous pubs and tax topics over the years. Most is derived from IRS Publication 527.

RENTAL PROPERTY ASSETS, MAINTENANCE/CLEANING/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.

 

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

@Carl  @ColeenD3  I'm not suggesting anyone is making anything up, but I am wondering if the canned response accounts for the situation.  I think what would help would be siting the section of the official source.  If I already have several single-family rental properties, is a new single-family rental property considered a "new business"?  If so, it would be considered a start-up cost, correct? If not, then it would be follow the normal rules of expense vs improvement, as it would be for an on-going business, correct?

 

Even this article states that they would be considered "Start-up costs", assuming this was considered a "new business", which I'm not sure it would be, since I'm in the rental business already.  If considered a start-up costs, then a person could deduct up to $5k (assuming you keep startup costs below $50k).   

 

For these type of articles, it would, of course help to site the year the article was written (and site a source), but does point to a book with a Dec 2019 publish date:

 

https://www.nolo.com/legal-encyclopedia/deducting-expenses-you-incur-before-your-real-estate-busines...

 

"maintenance costs for a rental property paid for before the property is offered for rent—for example, landscaping and utilities (but not the cost of connecting utilities)"

jack73
Level 3

Calculating cost basis for rental property purchase with renovation

Per TurboTax CPA,  when asked about utilities and insurance during the time of renovations to prepare the property for rent, "Since you where not trying to rent it at the time, it will be included in your improvement cost.  However, if the expense was incurred while you were trying to rent it, you would claim as expenses."

Carl
Level 15

Calculating cost basis for rental property purchase with renovation

I think what would help would be siting the section of the official source.

Did you yet notice the nolo site you referenced doesn't cite their source? There's a reason for that. They're getting their information from IRS Publication 535 which applies to a SCH C business or an incorporated business that produces "earned" income. There is no mention, reference or even an insinuation in that document of it applying to a passive business - which is rental property.

That information has been on the nolo site for more than 5 years, and it's their interpretation of the IRS regs - which I might add are regs that do not apply to passive activities.  Rental income is passive (with some exceptions which the likes of you and I don't meet or qualify for.)

If you "go there", you can fully expect an audit about 24-36 months after you file. Generally it's a paper audit done by mail, where the IRS "corrects" your tax return, notifies you of their correction and the additional amount of tax/fines that you owe. The letter gives you 30 days to either pay or provide supporting documentation to validate your claim. You'll pay because "supporting documentation" just doesn't exist.

Go their at your own risk and peril.

 

 

ColeenD3
Employee Tax Expert

Calculating cost basis for rental property purchase with renovation

Nolo is not the most reliable source. The IRS has specific rules that apply to rental property. You can't take one reference that applies to something else and apply it just because it is convenient to do so.

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