Deduction of Start Up Fees on Rental Property

[Dave918]

IRS Publication 527 does not allow me to depreciate startup expenses on rental properties on schedule E, i.e. taxes, insurance, cleaning, management fees, HOA fees, etc. incurred before the property was available/listed for rent. Does anyone know any other legitimate way to deduct these expenses? These are not improvements or physical property or closing expenses so I don't see how they could be added to the basis and capitalized/depreciated. I know some CPAs state that you can deduct up to $5000 in startup costs (and depreciate the rest over time) but other CPAs (and my tax guide) state the start up cost deduction is only for Active participation (Schedule C) businesses not for passive rental real estate (schedule E) activities. I don't itemize so I can't deduct the taxes under the $10K SALT state/local tax rule. Thank you in advance for your response.

[Carl]

Unfortunately, start-up expenses for residential rental real estate are flat out not allowed. Anything such as repairs, maintenance, utilities, etc. incurred before the property was placed in service have never been allowed. Do not confuse that with property improvements, which is a completely separate thing.

[Critter-3]

You can capitalize those expenses and add them to the cost basis which is depreciated. 

[lenushkina1]

@Carl 

Where do you find this info in the IRS literature?

Conversely, I am seeing a nolo dot com article (deducting-expenses-you-incur-before-your-real-estate-business-begins) stating the opposite, so I would love to find something directly from IRS supporting what you said.

Makes no sense for $10K painting job to be not deductible before the rental is advertised, but deductible after it is.

[tagteam]

See Section 195 of the tax code.

Start-up costs (expenditures) apply to active trades or businesses.

Nolo is deficient in many respects and contains some less than accurate information.

[lenushkina1]

I agree on "start up" expenses applying to active business.

However, my question was: where in the IRS literature it states that one can't deduct any expenses (eg. utilities, HOA fees, real estate taxes, repairs, etc.) before the property is placed to be rented (and it was never been in personal use). 

It isn't just nolo, I also am finding similar info (that these can be deducted) on other cpa websites (huddleston tax cpa) but I am not finding one way or another anywhere in the IRS docs, instructions or forms.

[GeorgeM777]

IRS Publication 527 Residential Rental Property states the following at page 4 regarding pre-rental expenses:

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.
 

Thus, your pre-rental expenses are not deductible.  We agree with the prior posts in that your pre-rental expenses should be added to the basis in your rental property.  This includes your "closing" expenses, such as appraisal costs, fire insurance, as well as your repair costs. The total of all of these pre-rental expenses represents your adjusted basis ( the cost plus all your pre-rental expenses).

@enlushkina1

[lenushkina1]

Thanks @GeorgeM777 

Let me see if I understand what you are saying:

Property is purchased on 1/1/22

Property is painted on 2/1/22 for $1000

Property is listed for rental on 3/1/22

Property is cleaned on 3/15/22 for $200

Property is rented on 4/1/22

The $200 is pre-rental expense that needs to be added to the basis and $1000 is not deductible in any shape or form?

Or

The $200 can be expensed and the $1000 needs to be added to the basis?

[DMarkM1]

The property was made available for rent on 3/1 and cleaned on 3/15 so that is a deductible expense.  Property was painted prior to the available for rent date so add that cost to the basis.

[lenushkina1]

Thanks, again.

So what I am having a hard time finding in the IRS sources is support for the fact that repairs and maintenance can be added to the property cost basis, before the property was available to be rented.

Also, what about property taxes, insurance, HOA fees, utilities incurred while getting the property ready to be rented (i.e. while remodeled) before available to be rented?

[GeorgeM777]

An interesting fact about rental properties is that all of the planning, organizing, and remodeling, while all done for the express purpose of making a property a rental property does not make the property a rental property.  What makes a property a rental property is when the owner makes the property available for rent, such as posting a "For Rent" sign on the property or posting the property online.  Whatever happens before the date the property is made available for rent, or whatever the owner's intention are with respect to the property before its made available for rent, does not matter for purposes of deducting rental expenses.   

Thus, if the pre-rental expenses cannot be deducted as rental expenses because the property does not meet the definition of a rental property, (it has not been made available for rent) then such expenses should be added to the basis of the property.  

Here is a chart from IRS Publication 551 which contains items that increase basis and those items that decrease basis.  Below the chart is a link to IRS Publication 551.  

IRS Publication 551: Basis of Assets

@lenushkina1

[tagteam]

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@GeorgeM777 wrote:
We agree with the prior posts in that your pre-rental expenses should be added to the basis in your rental property.  

Who agrees and where is the authority for that proposition? Please don't provide a link to any IRS instructions as they are not authoritative.

If an item is chargeable to capital account, then it can be added to the basis. Otherwise, an election can be made to charge carrying charges (primarily taxes and interest) to capital account. Otherwise, the expenses are either deductible as ordinary and necessary or neither deductible nor added to the basis.

See https://www.law.cornell.edu/cfr/text/26/1.1016-2

[AmeliesUncle]

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@tagteam wrote:

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Who agrees and where is the authority for that proposition? Please don't provide a link to any IRS instructions as they are not authoritative.

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While I'm not 100% certain and offhand I don't have any citations, I agree with George, at least in regards to the depreciable Basis.

For example, shipping and installation costs are added to Basis because those are what are required to put it "in service".  Likewise, the pre-rental expenses are what are required to put it "in service".

Again, I am not 100% certain of that and I don't have any citations right now, but it seems logical to me, at least for the depreciable Basis (whether or not the Basis for gain/loss would be different, I have no idea and you very well could be right).

[Carl]

, shipping and installation costs are added to Basis because those are what are required to put it "in service".

That's clearly stated in IRS Pub 546 on page 11 under "Cost as Basis". However, I've seen another pub of which I can't recall/find the number that basically states what you say. However, the publication I can't recall specifically and explicitly applies to what would be considered "earned" business income, and not passive income.

Unfortunately, all the pubs I've dealt with in that past that do relate to rental property/passive income, flat out do not address start-up expenses for passive income producing activities in any way, shape, form or fashion that I can find. Since there are pubs that "do" address those expenses for other types of income, I do not recommend anyone "try" the IRS on this for passive/rental income unless they have the resources to challenge it in tax court. (I do wish it would be challenged, so this matter could be put to rest once and for all. It's been going on for decades now.)

[tagteam]

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@AmeliesUncle wrote:

Again, I am not 100% certain of that and I don't have any citations right now, but it seems logical to me....

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Yes, I agree 100% that it is, indeed logical, but the Reg I cited earlier makes no mention of adding expenses such as maintenance and repair costs to the depreciable basis.

I would hate to have to go into an audit (albeit it would be highly unlikely that anything like this would ever be the subject of an audit) arguing that pre-rental maintenance/repairs are analogous to a Code or Reg section primarily applicable to an active trade or business (at which point I would be afraid they would simply whip out 1.1016-2).

Anyway, the solution (or workaround) is to make the property available for rent at the same time maintenance or repairs are being conducted. There is no reason the property has to be in absolute perfect condition to be "available for rent". [you would not believe the condition of some properties in my area - SWFL - that people are renting while their properties are being totally rebuilt from the ground up]