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?
@Carl you seem to be the expert on this subject, but I couldn't find a post on this.
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
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.
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.
@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.
@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?
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.
"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?
@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. "
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.
@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:
"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)"
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."
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.
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.
There is also a reference that states if a repair can't be separated from a major improvement, add it in with the improvement. I would have to do some research to find the IRS reference.
In the meantime, see this LINK.
IRS Pub 529 at https://www.irs.gov/pub/irs-pdf/p527.pdf page 4, bottom of first column.
Pre-rental expenses.You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.
I can't find anything, anywhere that allows you to claim in any way, the cost of preparing the property for rent for that first time between the time you acquire the property and the time it is available for rent, , or between the time personal property is converted to rental use and the time it's available for rent. Could I have missed it? Of course. But I doubt it.
Also can't find anything that lets one add the cost of those items that are clearly repairs and/or maintenance expenses to the cost basis. However, if a repair is done as "a part of" a property improvement that's going to be capitalized anyway, then common sense says you include that repair as "a part of" the capitalized improvement.
Example:
I'm adding an counter-top island in the kitchen which will undoubtedly add value to the house. My cost of doing this (includes materials, supplies and labor) gets capitalized and depreciated of course. In the process of doing this build-out I accidently punch a hole in a kitchen wall I'm not working on for this project. Now I have to fix this hole with a small piece of sheet rock, a few screws, plaster, sheet rock tape and paint.
Technically, this is a repair. But I can include the cost of that repair in the cost of the property improvement since I fixed it as "a part of" doing the improvement. It'll more than likely cost less than $100 for me to fix this hole, and it's not like I have to itemize every teeny-tiny thing with the IRS.
Are you "getting my drift" now? 🙂
From what I see this is probably what is commonly referred to as a "grey area" and I recommend that folks stay out of the grey. Besides, when you have a depreciable cost basis of say, $120,000 or more, increasing that basis by one or two thousand won't even put a dent in your tax liability over the years, since rental property (with a mortgage) is 100% guaranteed to operate at a loss (on your taxes) every single year.
The killer will be when you sell the property and have to recapture the depreciation. It's taxable in the year of sale and gets included as a part of your AGI for that year - thus making it likely you'll get bumped into a higher tax bracket.
I myself prefer to keep my depreciation as low as I legally possibly can for that very reason.
Okay, so if I think of it as a house I just bought for myself, and then converted to a rental, this makes more sense. I guess I just to use that mindset. In that situation, I don't get to deduct utilities, repairs, maintenance, or insurance, but I would track capital improvements, which increase my basis in the property. I'd also track mortgage interest under the "second home" category, I guess (which may reach the new max limit, when combined with my personal mortgage). Tracking mortgage interest for a few months and splitting it between pre and post "Ready to rent" is doable, but a bit of a pain. Guess you do the same for property taxes?
Understand that the date the property is converted to a rental (can be the date purchased) and the date the property is available for rent can be (and sometimes are) two different dates. Your allowed rental expenses that you can deduct, along with depreciation starts on the date the property is available for rent. For property improvements, the available date just doesn't come into play.
One thing I've seen others do with no problems is to include a "reasonable" amount of the cost of utilities (mainly electricity) in the cost of a property improvement. It takes power to run saws, floor sanders, cement mixers and the such.
" For property improvements, the available date just doesn't come into play."
But doesn't it, if, "depreciation starts on the date the property is available for rent."
Property improvements, by definition is what must be depreciated, correct? If I can't begin depreciating the building until it's available for rent, then the available date should also affect the new flooring (for example) that was installed between date of purchase and date available. I wouldn't expect to begin depreciating the flooring until the available date.
I meant to type "the purchase/acquisition date doesn't come into play"
I wouldn't expect to begin depreciating the flooring until the available date.
Of course. So if you tell the program you "acquired" the asset on 1/1/2019, and it was "available for rent" on 7/1/2019, depreciation starts on 7/1/2019. It really is that simple.
Now if this was a case of you purchased the property on 1/1/2019, installed the new flooring on 2/1/2019 (when the project was completed) and it was available for rent on 7/1/2019, I wouldn't bother entering the floor as a separate asset since depreciation on the property and the floor starts from zero at the same time. I'd just add the cost of the new floor to the cost basis of the structure and call it good.
For example,
Purchased property on 1/1/2019 for $200,000
Allocated $50K to the land (which is not depreciated of course)
The program "does the math" and figures that $150K goes to the structure for depreciation.
On 2/1/2019 installation of new flooring was completed at a cost of $10K. This makes my cost basis in the property $210,000.
When entering the property into TurboTax I'll enter $210,000 in the COST bos and $50,000 in the COST OF LAND box. The program will "do the math" and depreciation on $160,000 will start on my in service date of 7/1/2010. For depreciation, the fact that I 'acquired" (paid for) the new floor a month after I purchased the property has no effect what-so-ever on deprecation, since the property was not placed into service until after the property improvement was completed.