Out of state rental operating at loss. Which state do I claim the loss in?

[NW2206]

Hello,

I moved out of Arizona to California in December 2020 and converted my old Arizona house to a rental property. I didn't get a tenant until January 2021. As a result, because of maintenance, depreciation, and other expenses, the property operated at a loss in 2020. I am an active participant, so the passive income losses should be deductible against ordinary income. It seems like the loss could be taxable in AZ (since the income is from AZ) or in CA (since I incurred the expenses after I had moved to CA.) How do I claim those losses on my state tax returns without inappropriately double-dipping?

Thanks!

[AmyC]

You need to understand the rules. First, when did you put the house on the market? Do you have the ad date or purchase info to show the IRS when they ask?  

IRS Pub 527 for Rental Property states:

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.

Real Estate Tax and Rental Property TurboTax reader friendly article

Tips on Rental Real Estate Income, Deductions and Recordkeeping | IRS

Real Estate Tax Center | IRS

If you have any losses allowed, they would go on your resident return. Going forward, you will need to verify when you need to file AZ as it is prorated with your federal income and compared to the filing requirements for residents. Then, CA will give you some credit for taxes paid to AZ. The credit is the lower of CA or AZ tax on the same income.

Plus, if your income is high enough or your filing status is MFS, you don't get to deduct rental losses.  Welcome to being a landlord.

[Carl]

I moved out of Arizona to California in December 2020 and converted my old Arizona house to a rental property.

Personally, I would not bother with this for the 2020 taxes for several reasons.

1) We're talking less than a month. So the way the IRS does things, at best you'll get 15 days of depreciation.

2) There was no rental income in 2020

So I would wait until next year when doing the 2021 taxes and convert the property from personal use to rental property with a conversion date and an in service date of 1/1/2021.

It seems like the loss could be taxable in AZ

You got that backwards. You don't pay taxes on losses. You pay taxes on gains, and if there's a mortgage on the property, then it's not common at all for residential rental real estate to actually have any taxable gain each and every year it's classified as a rental.

Also, more than likely AZ does not qualify as your resident state for 2020 - not even as a part year resident based on what I read in the first paragraph at https://azdor.gov/sites/default/files/PROCEDURES_INDIV_1992_itp92-1.pdf

[NW2206]

In the month I lived in California (December 2020), I had to expenses for slight maintenance like painting and other refurbishments plus cleaning, utilities, etc. Including depreciation, net loss in that month was almost $3,000. I don’t understand why I wouldn’t want to claim that loss in 2020 to reduce my other taxable income (as an active participant, I can reduce my ordinary income). I don’t see the benefit of not claiming it was business purpose until 2021 and not claiming those losses in 2020. I should have a order myself better; I understand losses are not taxable and actually tax-beneficial. My only question was how to claim the losses for my state returns. 

I was certainly a part-time resident of Arizona in 2020: I lived and had job there for 11 months. However, I also lived in California and also had a job there. I have to file part-year resident returns in both states.

I understand how to split up my W2 and 1099 income. But it’s not clear to me how to split up the losses from the rental property. It was from an AZ source but also occurred while I was a CA resident. 

[Carl]

For starters, the property is not available for rent, until it's actually move in ready. If you incurred expenses in the process of making it move in ready, then it wasn't move in ready and "in service" until those repairs were completed.

Repair expenses, as well as maintenance expenses, are not deductible when preparing the property for rent for that very first time. They never have been deductible either. So expenses incurred prior to the property being "in service" (meaning move-in ready) are just flat out not deductible and never have been.

So if you incurred $2000 of expenses in the process of preparing the property for rent for that very first time, they're not deductible.

Now if the property was in fact, move-in ready on say for example, Dec 27th, then that's your in-service date. For depreciation purposes only the mid-month convention is used and depreciation will be figured from Dec 15th, through the end of the year, regardless of what day in December the property was actually placed in service.  The only way I see for you to have anything close to $1000 of depreciation for the last 15 days of 2020 is if your cost basis in the structure is more than around $650,000. Based on my extremely limited knowledge of the real estate market, I only see that possibility if the property is located in CA or NY. Since your property is in CA, that's a given.

I also question $2000 or more in "repair" expenses. Sounds more like property improvements to me. But then, I don't live in and don't own property in such a high cost of living state either. So $2K for repairs may be perfectly normal and acceptable for the location of your property.