Expenses before renting

[cpgnv23]

Thanks for your input so far on this topic.  I have some other questions related to converting a second home to a short term rental property.   

Once I have figured out the original basis for the property (original cost + capital improvements since purchase....all before service date), can I use that depreciated cost as a deduction each year? 

I already had the mortgage in place for a few years before we changed it to short term rental.  Can I now just deduct the cost of the mortgage (principal, interest, taxes)? 

What about pre-rental expenses not tied to the actual physical property?   I bought a house full of furniture and a bunch of supplies (towels, consumables, kitchenware) without which i would not be able to rent the house.   That's not capital expenditure, so is there no way for me to deduct that? 

Also. what about expenses related to the "business" of renting house not tied to the actual house....for instance professional advice (real estate, CPA, legal).   There's space for those expenses in the Turbo Tax questionnaire, but they are in post-service date section.   Does the IRS really expect you to wait until after you start renting a house to incur professional expenses about renting the house?   It makes no sense. 

[DianeW777]

It depends.  You are allowed Start Up expenses, covered below. The answers to your questions are listed below.

1. The original cost basis will be used as an asset for your business and must be depreciated and you will use the calculated depreciation expense each year you rent the property.
2. You can deduct the mortgage interest and property taxes using the prorated amount for the rental period in the first year and then if rented full time in 2024 you can use the full amount paid for the  year. 
   1. Principal payments on the mortgage are never a deduction, you are already using the full cost of the home as a depreciable asset (it's the same money).
3. The expenses before the property was available, but were necessary to prepare for making it available for rent are 'Start Up Expenses'.  However the IRS indicates the activity must be 'for profit' and residential rental properties are considered 'passive income' activities. This factors into how the start up costs for a rental should be treated, which is different than a profitable trade or business.  See information below about passive activity for rental real estate.
   1. Your start-up costs are accumulated until you become operational.  Expenses such as pre-operational acquisition costs, investigation costs, proof-of-concept costs are included in start-up costs. For a residential rental activity you should add these costs to the property as part of the cost basis, then use the total as the cost of the home for depreciation.
   2. The Asset Selection is Rental Real Estate Property > Continue (see the image below)
      • Must be only the rental portion if not converted to a rental full time

Active participation is a requirement to be allowed to reduce other income by the loss on your rental property.  There is also an income limit that begins to reduce that amount.

Phaseout Rule: The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that’s more than $100,000 ($50,000 if you’re married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you’re married filing separately), you generally can’t use the special allowance. This is because the special allowance is reduced to $0 since the modified adjusted gross income is over the $100,000 amount.

• Sign into your TurboTax return > Search (upper right) > Type rentals > Press enter > Click on the Jump to... link > Edit next to the Rental Activity  > Edit next to the Property Profile or General Info > Continue to the question about active participation
• Continue to the end of the section for TurboTax to save your changes.

@cpgnv23

[Edited: 03/25/2023 | 6:02 AM PST]

[Carl]

Some of the information provided by @DianeW777 is not complete and could easily be misunderstood.

For rental property reported on SCH E, start up expenses are not allowed. Start up expenses are allowed only if the rental qualifies as a SCH C business and is actually reported on SCH C. It is not common for long term residential rental real estate to qualify as a SCH C business, as it can be very difficult to meet the requirements to qualify as a SCH C business. For a "down to earth" explanation, see https://www.landlordstudio.com/blog/schedule-c-vs-schedule-e

Cost Basis - Generally, this is what you paid for the property when you originally purchased it. You add to that cost basis anything you paid for property improvements after your original purchase. Understand that there is a difference between property improvements, repairs, and maintenance expenses.

Depreciation - Land is not depreciated. Your cost basis for depreciation is the value of the structure, plus the cost of any property improvements to that structure that you paid for after your initial purchase of the land. The program (not you) will help you to determine the value of your land and the value of your structure including property improvements.

Rental property uses the mid-month convention for deprecation. So depreciation starts on the 15th day of whatever month you place the property in service. Basically, it's "in service" on the first day a renter "could" move in. That's usually the day you put the FOR RENT sign in the front yard. So it doesn't matter if your in service date is March 1st or March 31st, depreciation starts on March 15th. But the actual date does matter for other rental expenses.
Generally, any costs incurred in the process of preparing the property for rent for the very first time are not deductible. This does not include property improvements. Property improvement costs are added to the cost basis of the property, and it does not matter when that property improvement was done, so long as it was "after" your initial purchase of the property.

[tagteam]

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@Carl wrote:

It is not common for long term residential rental real estate to qualify as a SCH C business, as it can be very difficult to meet the requirements to qualify as a SCH C business. For a "down to earth" explanation, see https://www.landlordstudio.com/blog/schedule-c-vs-schedule-e

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Some of the information on that web site is woefully inaccurate; it should not be cited. For example, it is stated that:

For investors with multiple rental properties Schedule C might be the right choice if you qualify for the real estate professional status.

The foregoing statement is misleading and mostly false. Real estate professionals typically report on Schedule E and never report on Schedule C unless they provide significant services to renters or are real estate dealers.

The information on the site could also lead users to believe that all losses reported on Schedule E are passive, which is not true.

[xedd2kh]

Carl - thanks for your feedback.   Although I didn't give a detailed description of my rental activity, I did categorize it as a short term rental property.  I guess for that reason Diane assumed it was going on a Schedule C.   From what I can see in the average length of stay rule, I have to report this on Schedule C.  The odd thing though is that TurboTax doesn't take me there.  In the interview it asks all kinds of questions but defaults me to Schedule E even though I don't qualify.    I'm at a loss as to how to get the benefit of all the Q&A but put my info on the Schedule C where it belongs.   If I delete the schedule E, then I will lose all my info.   Seems like a mess!

[AmyC]

Yes, transferring information from the sch E to the C is a very involved process and I recommend you save a copy of your return with all of the sch E worksheets and information and move part at a time to the sch C.

To print or view  your forms:

• In desktop, switch to Forms Mode. 
• For online:
  1. On the left side, select  Tax Tools
  2. Select Print center
  3. Select Print, save or preview this year's return
  4. If you have not paid, select pay now.

@xedd2kh 

[tagteam]

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@xedd2kh wrote:

.........From what I can see in the average length of stay rule, I have to report this on Schedule C....

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No, you do not have to report the rental on Schedule C unless you're providing significant services to your renters.

See https://www.irs.gov/instructions/i1040se#en_US_2023_publink24332td0e1083

Generally, rental real estate activity is reported on Schedule E even if it is also a trade or business activity; however, if you provided significant services to the renter, such as maid service, report the rental activity on Schedule C, not on Schedule E. Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, or similar services.