Restoration Expenses from water damage of the rental property

[gulsheenk]

Hello, 

My rental property has a large damage from the water leaking / streaming from the ceiling.  Insurance will be covering restoration inside my unit. However, there are a few other big ticket expenses:  mold restoration (insurance covers $5K only and remaining amount is on me),  coil replacement of the air handler in the attic ($2K).  Insurance is conducting liability investigation and then may cover expenses for the attic and the unit below damage restoration. 

Just wondering what all I need to keep in mind and consider when I file 2023 taxes next year ?!?

Thanks! 

[Mike9241 · Accepted solution]

unless you upgrade, I would treat all the out-of-pocket $$$ as repairs  (ie net of any insurance reimbursements) 

[Carl]

I have a few things to contribute here. Your explanation and description of damage causes my imagination to run in several directions.

First, one has to determine if the work done is a repair expense, or a property improvement. The definition of each is below. It's a bit lengthy, but necessary. Which would you consider this?

     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.

     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.

[gulsheenk]

Thanks a bunch, @Cham , for your detailed response.  So, based on the definitions, it is repair  - "expenses incurred to return the property or its assets to the same usable condition they were in". And this is a rental unit; I have lost rent as well as it is unusable and my tenant has been staying in a hotel.  I have the following questions:

A.) Within Turbotax, do I report it under Wages and Income --> Rental and Royalty Summary --> Any Repair Expenses ?

B.) Because it is repair (not replacement / improvement), I think, I can report/deduct entire amount out of my pocket (insurance premium + uncovered amount by insurance) in the year and do not need to expense over 27.5 years.  Please confirm.

C.) This water damage has depreciated my condo's value.  How do I compute this depreciation?

D.) Wondering if I can report lost rent? if so, how?

And, thanks for sharing the IRS link.  From the section "What is the de minimis safe harbor election?" :

i) how do I get this "applicable financial statement (AFS)" ?

ii) Wondering if restoration of property falls under "production of property" from the definition below?

The de minimis safe harbor is simply an administrative convenience that generally allows you to elect to deduct small-dollar expenditures for the acquisition or "production of property" that otherwise must be capitalized under the general rules.

Thanks! 

[RobertB4444]

If you are sure that these are repair expenses and that at the completion of them the property was returned to the value it had before the water damage then yes, you will enter them under repair expenses.  

Be sure to only enter those expenses for which you did not receive insurance reimbursement and retain any records that prove this.  Also, retain any records that show that the value of the rental home was not increased or improved by the repair work.  As long as the fact that the value of the home has not increased is true then you can deduct the repair expenses in the year that they occur instead of depreciating them.  

If, after all of the repairs are done, the value of your home has gone down then you will receive benefit for this upon the sale of the property.  You will not decrease the basis at this point because of the water damage.  But when you sell the loss will reflect the decrease in value.

You can't receive a deduction for lost rent.  Since you didn't take it into income you can't take a deduction for it.

The 'applicable financial statement' that the IRS refers to is the one you create in reference to managing your property.

The production of property is referring to creating a new rental space.  If your repairs changed the rental space in any way to make it better than it was when you first started then you have the production of property.

@gulsheenk 

[Carl]

I have lost rent as well as it is unusable and my tenant has been staying in a hotel.

You haven't "lost" rent. You can't lose what you never had to begin with. You'll just have less rental income to report is all. Also, check your policy payout documents. Most rental policies include a "loss of rents" provision where the insurance company will pay up to 85% of lost rent for a set amount of time. Generally anywhere from 6 months to a full year. So if your payout includes an amount for rent, you just report that amount as rental income.

A.) Within Turbotax, do I report it under Wages and Income --> Rental and Royalty Summary --> Any Repair Expenses ?

Yes. But you only report what you paid out of pocket.

B.) Because it is repair (not replacement / improvement), I think, I can report/deduct entire amount out of my pocket (insurance premium + uncovered amount by insurance)

For rental property your insurance premium is already a deductible expense every year you pay it. So you can't claim it twice. You can only claim your out of pocket expense.

C.) This water damage has depreciated my condo's value. How do I compute this depreciation?

For starters, if the insurance company is paying for the repairs, then it's returning the property to same condition it was in prior to then event. So I don't see how there's any loss in value. Also, the TTX program does have it's limits. Under no circumstances and with no exceptions do you ever change the value of an asset that's already being depreciated. Doing so *WILL* completely screw the depreciation history of that asset and all future depreciation will be wrong.

D.) Wondering if I can report lost rent? if so, how?

Again, you have no loss to report on that front. All you would have is less rental income to report. But like I said, check your policy payout papers. I would fully expect your policy to include in the payout an amount for "loss of rent". If so, then you are required to include that payout amount in the rental income received for the entire tax year. Basically, the insurance company is renting the property from you for the period of time they paid for. Typically, insurance policies on a rental will cover anywhere from 50% to 85% of the loss of rent for a specified period of time.

"What is the de minimis safe harbor election?" :

Basically, it allows you to expense certain items that would otherwise be capitalized and depreciated over time if the cost of that item was less than $2,500. But if you're dealing with repair expenses only, this wouldn't be of concern.

 For the rest of your items, you can google it at your convenience. For example, if I google 'Applicable Financial Statement IRS" one link takes me to https://www.law.cornell.edu/definitions/uscode.php?height=800&def_id=26-USC-1830802281-314845245&ter...

[gulsheenk]

Thanks a bunch, @Carl , for your comprehensive responses.  This is very helpful.  

Best!

[gulsheenk]

This is helpful.  Thanks for replying to all points.  

Best!

[Anne F]

Dear Experts on this thread, 

I have a very similar question to the one posed in this thread that was answered so well.  I also had a huge water loss in a rental property.  3rd floor bathroom had a catastrophic pipe failure and tenants were out of town.  By the time they returned, the whole property was soaked through.  Every floor, most walls and ceilings on all of the lower floors had to be ripped out.  It was down to studs to dry out.  

It had been a rental property for 12 years, and is now currently rented again.  The time period spanned over 2 years (it was a really big house), but the actual restoration and renovation work only started in 2023.  

I'm trying to figure out if I write off some of the previous undepreciated portion of the home in the 2023 tax year ( yes - i know I'm very late - but have paid in well enough to cover me from penalties and interest) and how to report all of the new balances.  We did have a mix of things covered by insurance and those that we chose to upgrade as with everything gutted it was the perfect time to do some repairs.  The overall split was probably around 60% restoring property to previous level, 40% upgrades to the property. 

We did get covered for our loss of rental income by insurance but only for 1 year. 

My questions are how do I write off part of the previous depreciable base of the property.  For example, 1 bathroom, a laundry room, a kitchenette were destroyed in the leak, but the main kitchen was fine as well as the other bathrooms.  

Any help would be much appreciated. 

[Carl]

I'll try my best here.

My questions are how do I write off part of the previous depreciable base of the property.

Because of the way the program is designed, it really can't handle these types of situations correctly. But there is "a way" to do it correctly if you don't mind going around your elbow to get to your thumb and "then" jump through a few hoops of fire. 🙂 First, lets deal with the loss separate from the upgrades.

The 60% Loss

Get into the assets section. understand that the value of the land will never change.

Next, reduce the value of the structure by 60%. If doing this doesn't reduce the prior year's depreciation by 60%, then you reduce it manually. If that doesn't make the current year's depreciation reduce by 60% from what would have "normally" been taken, then you can reduce it manually. (Once you reduce cost basis of the structure and prior year's depreciation manually if necessary, I would expect the program to auto-compensate with the "new" correct current year depreciation.)

Next, enter a completely new asset classified as Residential Rental Real Estate using the original in service date. Enter the structure value of whatever your 60% loss is, and of course the land value on this new asset will be zero.

Next, you will report the sale of "only" this newly entered asset to the insurance company for whatever the insurance payout was. I know full well that the depreciation recapture on this will be "recaptured". That gets handled once this sale is reported.

For the recaptured depreciation of what was lost, you'll report and include that amount in your total loss under the Deductions & Credits tab in the Casualties and Thefts section.

For the 40% upgrades/property improvements

Enter that as yet another new asset classified as Residential Rental Real Estate with a cost basis of whatever that 40% is for the structure, and a value of zero for the land. The in service date will be whatever date on or after the work was completed and the updated/upgraded property was available for rent.

[M-MTax]

We did have a mix of things covered by insurance

You need to say what those things are. It makes a big difference in the calculations. The amount you received is not taxable if used to effect repairs and restore the property to its original condition.

We did get covered for our loss of rental income by insurance but only for 1 year. 

That part of the insurance recovery has to be reported as rental income for the year it was received.

[uwrgtriangle]

For your 2023 taxes, keep detailed records of all restoration expenses, including receipts and insurance payouts. You may be able to deduct unexpected repair costs as rental property expenses. Check if any losses qualify for casualty loss deductions under IRS rules. Consulting with a tax professional will ensure you maximize deductions and comply with tax regulations.