For rental property:
- Expenses associated with acquisition of the rental property are added to the cost basis of the property. An example of this would be the title transfer fees paid at the courthouse to take the seller's name off the deed, and put the buyer's name on the deed.
-Expenses associated with acquisition of the loan are amortized (not capitalized) and deducted (not depreciated) over time. Examples of this would include points, loan origination fees, survey fees if the lender required a survey as a condition of loan approval, and the loan application fee only if the loan was approved. Any of these fees you paid on a loan that did not go through or for a property you did not buy are a personal expense and not deductible anywhere on your tax return.
we haven't formed an LLC yet, doing the sole proprietor route.
I highly suggest you don't waste your time and money with this for rental property.
Additional Information For Rental Property Owners
The below is not to deter you from making a business the legal owner of your rental property. It's more to educate you so that you can make an informed and educated decision. Any decision you make should not be based only on the information provided here. You should seek legal advice not just from a tax professional, but from a "legal" professional knowledgeable in all the legal aspects outside of the tax ramifications of your decision.
Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Laws differ on this from state to state, so this may not be “entirely” true to the degree you may think it is. It can be easy for the business owner to unwittingly make a mistake that allows the legal piercing of that protection.
If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. In some states, that “veil of protection” offered by an LLC is so thin, even a new first-time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. It’s mostly because the property owner made the mistake “just one time” of mixing personal expenses with business expenses. In fact, many legal firms will give such cases to their “new hires” right out of law school because it’s a great confidence builder for them since it’s practically a guaranteed win for the tenant. There may be other legal problems and issues with this too which have nothing to do with taxes.
In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash or other assets on hand to pay for it in full, your LLC may never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you that while not impossible, the chances are that’s not going to happen.
When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a long-term rental property produces “passive” income. (the definition of a long term and short-term rental can differ not only from state to state, but from lower level taxing authorities within the state.) What’s the difference?
Earned income is income which you have to do out and “do something” in order to earn it. This income is subject to regular income tax, and also an additional 15.3% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.
Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.
SO if you create an LLC for your rental property, there are two things that will NOT happen.
- You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
- You will not report one penny of rental income or one penny of rental expense on SCH C.
So in the end, you will be filing a zero income/expense SCH C with your personal tax return.
Now let’s say you decide to file the 8832 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on form 8825 as a part of the 1120-S Corporate Return. Then the corporation issues each owner/member a K-1. Each owner/member enters the K-1 on their personal 1040 tax return, and the rental information ends up on page 2 of the SCH E as a part of your personal tax return. But keep in mind the S-Corp election for an LLC is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 8832 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.
SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan. Overall though, it’s still financially dumb to do this. Here’s why I say that.
When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time. A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.
One mistake I see quite often is that when an owner converts their primary residence or 2nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case. If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.
