This is the first year we have rental income(passive), and doing tax planning now,
Here's some basic info.
Generally, when it comes to long term residential rental property you can expect to always show a loss "on paper" every single year at tax filing time. Especially if there's a mortgage on the property. When you add up the deductions of mortgage interest, insurance, property taxes and the depreciation you're required to take by law, those four items alone will usually add up to more than the total rental income received for the entire tax year. Add to that the other allowed rental expenses such as repair, maintenance, HOA fees, etc. and you're practically guaranteed to show a loss on the SCH E every single year.
Assuming you've owned the property for some time before converting it to a rental, that first year amounts will be way off. For example, if you converted the property from personal use to a rental in July, the depreciation taken will be significantly lower by about half, of what it will be for the next full year. Additionally, your mortgage interest deduction along with the property taxes will be split between SCH A for the period of time the property was personal use, and SCH E for the period of time the property was rental use.
Property insurance will also be prorated on the SCH E for the period of time the property was a rental. The insurance is not deductible at all for the period of time it was personal use. So there will be nothing on SCH A for property insurance.
When it comes to the cost basis for figuring depreciation, that gets figured based on the "LOWER" value of what you originally paid for the property, or it's FMV on the date you converted it to a rental. Whichever is lower. Typically, what you paid for the property originally will be the lower amount, and is what is used for figuring depreciation over the next 27.5 years.
Take note also that to your cost basis, to that you add any costs that you paid for any property improvements since your original acquisition of the property. It does not matter if the property was personal use or rental use at the time of the property improvement. It still add value to the property, thus increasing the cost basis.
Being your first year dealing with rental property on your taxes (I presume), it is important to get it set up correctly in TurboTax. Even the tiniest of mistakes can (and will) grow exponentially over time. Then when you catch the mistake years down the road, usually in the tax year you sell the property, the cost of fixing it can (and will) be expensive. So absolute perfection in that first year is not an option; it's a must. The below information is provided to help you avoid some of the more common mistakes I've seen over the years. Of course, if you have questions on it, then by all means asks. If I can't answer, others will.
Rental Property Dates & Numbers That Matter.
Date of Conversion - If this was your primary residence or 2nd 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 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.
