Expenses before renting

[mikenandria]

My wife and I have an LLC and purchased a rental home.  If possible, please provide references to IRS documents (e.g. publications) as part of your answer.  How do we report expenses that we incurred before renting the property?  Do we depreciate it or expense it?  If we depreciate it, are we allowed to break out some of the major items separately (e.g. new HVAC, new flooring), or must it be rolled into the cost of the house?

[PatriciaV]

Any expenses you incurred before you listed the property increase the basis of the property and should be entered as separate Rental Assets, subject to depreciation. 

IRS Pub 527 Adjusted Basis: "You must increase the basis of any property by the cost of all items properly added to a capital account. [This] include[s]…[t]he cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year."

[mikenandria]

Patricia,  thanks for your answer.  I think that you are saying that all the expenses before renting should be capitalized, and that yes, I can break some of them out, like new flooring and new HVAC system.  Is this correct?  It makes sense to me to do that, since the items mentioned may have a shorter depreciation time.

[Carl]

There is a difference between expenses, and property improvements. Things like a new HVAC, flooring and the such are property improvements. Those get capitalized and depreciated over time.

For all property improvements done before the property was converted to a rental, you can just add them to the cost basis and include them in the cost basis of the structure. That makes more sense since the in service date for all improvements done before converting to rental, will have the same exact in service date as the property.

I also find the program doesn't provide the clarity I think it should, when you are first setting up a rental in TurboTax. Therefore, here's some general guidance on that which you may or may not find helpful.

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence or 2^nd home before, then this date is the day AFTER you moved out, or the date you decided to lease the property – whichever is later.
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 was contracted to move in, and/or "could" have moved in. That would be your "in service" date or after if you were asked for that. Vacant periods between renters do not count for actual days rented. Please see IRS Publication927 page 17 at https://www.irs.gov/pub/irs-pdf/p527.pdf#en_US_2020_publink1000219175 Read the “Example” in the third column.
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, 2nd home, or any other personal use reasons 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 Improve, restore, or otherwise “better” the property. Basically, they retain or add value to the property.

Betterments:
Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property. An example of a pre-existing condition or defect in this context would be something such as foundation repair (slab jacking) or some other, hidden and costly, anomaly.
Restoration:
Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.
Adaptation:
Expenses that may be for adaptation include expenses for altering your property to a use that isn’t consistent with the intended ordinary use of your property when you began renting the property. Adding a wheelchair ramp would be an example.

Expenses for these types of costs 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 need to 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 retain or 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.

There are rules that allow you to just flat-out expense and deduct some property improvements instead of capitalizing and depreciating them, if the total cost of the improvement was less than $2,500. It’s referred to as “safe harbor di-minimis” But depending on the specific situation, this may or may not be beneficial. Just be aware that not every property improvement that cost less than $2,500 qualifies for this. If this interest you, the rules can get complex. So a good place to start reading is on the IRS website at https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations. The stuff on di-minimis starts about one page down.

Cleaning & Maintenance

Those expenses incurred to maintain the rental property and its assets in the usable 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 for the very first time are not deductible.

Repair

Those expenses incurred to return the property or its assets to the same usable 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 for the very first time 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 3^rd 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.

[JillS56]

No, do not breakout the costs of the new flooring or HVAC.   These costs get added to your property basis.  IRS Publication 527  says 

To figure your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service for business or the production of income. The result of these adjustments to the basis is the adjusted basis.

You are correct on adding the painting to the cost basis as you cannot expense this now because the painting occurred before you began renting out the property.

If the flooring or HVAC was done after you began renting the property, then they would be listed as separate assets.

[tagteam]

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@mikenandria wrote:

....yes, I can break some of them out, like new flooring and new HVAC system.  Is this correct?  It makes sense to me to do that, since the items mentioned may have a shorter depreciation time.

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The short answer is that you cannot "break some of them out" before the rental is placed into service; you have to add the costs of those improvements to your basis and depreciate the resulting total over 27.5 years (at the time the property is placed into service as a rental.

[mikenandria]

Thank you Carl very much for all the information!  I understand what you are telling me, that I can't deduct minor type repairs before renting, but it seems like JillS56 is saying I can add these expenses (e.g. painting) to the cost basis, and thus depreciate the amount.  What do you say?  I have about $6000 worth of pre-rental expenses on things like utilities, painting, landscaping, plumbing, electrical, etc. that I would like to depreciate, if possible.  Can I add these to the cost basis of the house?  Is there a way to do that legally?  I also have heard of claiming them as "start-up costs", but I'm not familiar with this process.  Any advice you can give would be appreciated.

[Carl]

I have about $6000 worth of pre-rental expenses on things like utilities, painting, landscaping, plumbing, electrical, etc. that I would like to depreciate, if possible.

I would think you would want to keep your depreciation amount as low as legally possible each year. Remember, depreciation is not a permanent deduction. When you sell the property all prior depreciation is recaptured and taxed. Two things to keep in mind with that.

1) Recaptured depreciation is added to your AGI

2) The increased AGI can have the potential to bump you into the next higher tax bracket.

"Expenses" incurred before the property was placed in service and "available for rent" are flat out not deductible. Period. If they are, then someone please point out to me in IRS Publication 527 at https://www.irs.gov/pub/irs-pdf/p527.pdf where it says you can.

"Property improvements", as I defined earlier in this thread, are added to the cost basis. It does not matter when the property improvement was done either - be it before you converted it to a rental, or after. It still adds value to the property.

Typically, with property improvements done before you converted the property to a rental, those will have the same "in service" date as the property itself. So they can just be added to the cost basis and included in that initial asset entry for the property itself. If it's a depreciated improvement, it gets added to the structure cost. If it's a non-depreciated land improvement, it gets added to the land cost.

Now you can list "all" property improvements as separate assets if you want, even though they may have the exact same "in service" date as the property itself. But either way you do it, it still increases the over all cost basis any way you look at it.

Generally, the only time you would enter a property improvement as it's own separate asset, would be if that improvement is placed "in service" any time after the property was originally converted and placed in service. I know others enter them separately no matter what, for their own book keeping needs.

[mikenandria]

Hey Carl, thank you so much for your time, in answering my questions.  I hope that you have a blessed week!

[stevenf]

Hi Carl,

You are GREAT! I have been reading your posts and they are really, really helpful however I cannot seem to get confirmation on this expense:

PAINT!

 Assume I spent 350.00 on paint in late 2020 to decorate my condo to beautify it so renters will sign on the bottom line.  Well , they liked my paint job and signed my lease. My rental was posted for rent 12/20 and they signed for 01/01/2021. All is well going on 2 years.

NOW IS THE PAINT I purchased deductible in any way? (forget all my labor involved countless hours). I have been reading the IRS will not allow paint to be deductible, capitalized, depreciated unless it is "wrapped" in as expense under a "REMODEL". 

Can you please clarify once and for all to the END OF TIME is paint deductible as listed in the above situation?

I understand paint and all supplies are deductible once the rental "STARTS" but what about prior?

Thanks for you postings!

Stevenf.

[Carl]

Do not confuse what I'm about to say, with capital improvements, sometimes referred to as property improvements, or betterment's. Improvements are their own completely separate beasts.

Expense incurred before the property is placed "in service" and available for rent are not deductible. Period.

The earliest a residential rental property is considered in service is on the first day that a renter "could" have moved in.

[tagteam]

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@stevenf wrote:

I understand paint and all supplies are deductible once the rental "STARTS" but what about prior?

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You can deduct the cost of the paint you purchased and all ordinary and necessary supplies for the tax year in which they are purchased provided the property is available for rent.

Since you purchased (presumably paid for) the paint in the 2020 tax year, you can only deduct that expense on your 2020 income tax return.

[Carl]

@tagteam is basically saying the same thing I said. If the property was not in service and available for rent on the date the expense was incurred, then it's not deductible.

[stevenf]

Ok Carl, thanks for clarifying. 

[stevenf]

Ok, thank you tagteam for clarifying.