Will closing costs and major improvements undertaken before a rental property was put into service increase its basis for depreciation? TurboTax is not doing this - why?

[ashley-r-lynn]

I converted a condo that was my second home into a part-time rental this year. After purchasing the condo, I renovated it, all before putting it into service. Turbotax is asking me about home improvements, as well as closing costs, for the property, but then for some reason is not adding either to the basis it says I can depreciate. Why would this be?

[Carl]

I converted a condo that was my second home into a part-time rental this year

Your amortized closing costs (if you actually can claim them) "should" appear as a completely separate item in the assets/depreciation section. Now if the property was actually purchased prior to the current tax year you're filing, then they won't be listed there since they were fully deductible in the year you purchased the property.

The closing costs were fully deductible in the tax year you closed on the purchase if one or more years before you converted the property from personal use to a rental. So you can't double-dip and claim those costs again in the year you convert the property to a rental. To further clarify closing costs if the property was purchased in 2021 and then placed in service in the same tax year:

 - Those costs incurred for acquisition of the property are added to the cost basis of the property. For example, the title transfer fees paid at the courthouse to remove the seller's name from the deed and replace it with your name.

 - Those costs incurred for acquisition of the loan are amortized and deducted (not depreciated) over the life of the loan. Examples would include loan application fees and survey fees if a survey was required as a condition of loan approval. You can not claim/amortize these costs if the property was purchased in a prior tax year and was not place "in service" as any type of business property in that same year of purchase.

Property improvements do add to the cost basis for depreciation, and it doesn't matter when they were done either, weather done before or after converting the property to rental.

I would suggest you enter the property yourself in the Assets/Depreciation section. That way, your one entry for the property itself can include your property improvement costs, for those property improvements done before it was converted to a rental.  Since the property and the improvements done will all have the same "in service" date, the year the improvement was actually done doesn't really matter. This actually makes it easier and simpler.  Just remember, your property improvements add to the cost basis of the structure; not the cost basis of the land. (Unless you did land improvements, of course.)

Finally, when working this through the TurboTax program, there are some things that (in my personal opinion) are not really "clarified" the way I think they should be. This results in some folks not correctly interpreting what the program is asking for. Therefore, I offer the below in case you find it helpful.

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence or 2^nd 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.

[ashley-r-lynn]

This is so helpful - thank you!

The closing costs point makes sense to me, as does your explanation of the improvement cost. However, the program doesn't seem to allow this approach.

On the property improvements, you say "I would suggest you enter the property yourself in the Assets/Depreciation section. " The program does not seem to let me do that. When I tell it that I both "converted a home to rental property" and "rented a property for the first time", it puts me through a bunch of questions. One asks for the date purchased, date put in service, and "original purchase price". The next page asks "what was the fair market value". I'm assuming they mean on the date of purchase, not the date it was put into service, so I put the original purchase price again. The next page asks me escrow fees (thank you, I now understand why these won't be included in basis), and the page after that asks "what improvements did you make before renting out [property name]. It has a box that says "home improvements total", and I have put the renovation cost in there. It then asks a couple irrelevant questions to my situation, before announcing that my cost basis is [original purchase price]. It does not seem to be adding the renovation that it specifically asked for. I am so confused on this part.

Thank you again for your help!

[ashley-r-lynn]

One other thing - my version of turbotax doesn't ask about personal days AFTER the conversion to a rental, it asks about personal use days throughout 2021 (which would make sense, since IRS allocation of annual costs as rental expenses is based on [rented days/total days rented or used for personal purposes]. Maybe they changed Turbotax to make it clearer?

[Carl]

I just re-read your original post. You indicate you converted it to a "part time" rental. The IRS term for that is "short term rental". If your intention is to rent it for less than one year, then it's a short term rental and personal use days for the entire tax year, regardless of your date of conversion, do count against you. Your allowed rental expenses including depreciation will be reduced based on the number of days you lived in the property at any time during the tax year.

If you are going to be converting the property between personal use and rental use each year, this creates it's own nightmare for you down the road. When a personal use property that was once rental use is converted back to a rental, you have to reduce the cost basis of the depreciable assets (which does not include the land) by the total amount of depreciation already taken in the past, and depreciation starts all over from that new cost basis. This means the amount of depreciation taken each year will be different, and reporting the sale or other disposition of the property in the future has the potential to be a mental and mathematical nightmare. In most cases, the TTX program can't handle the situation automatically, and requires the user to manually "do the math", thus increasing the possibility of user error.

[ashley-r-lynn]

Thanks, Carl.

It's true that I am only renting out the property some of the time, and I'm aware that expenses like mortgage interest and depreciation will be allocated between personal use and rental use. But the issue is not the depreciation expense, but rather the basis. The program is not counting any of the improvements in the basis, and instead is just using the original purchase price. I think it is a programming glitch and I'm wondering if anyone else has experienced it, and whether there is a workaround.

[Carl]

and whether there is a workaround.

The workaround is in my first response. But one could easily have missed it. Simply go into the Assets/Depreciation section and enter the property there as an asset. That way you (not the program) decides and sets what the cost basis is.

If when you get into the assets/depreciation section you see the property already there. Simply elect to edit it, and you can change the numbers as needed.

[jdufford]

Hi, I have a similar situation and I'm wondering if you can clarify. In my case, I bought a condo in 2005. Paid too much, as was the market. I married in 2008. Value tanked and we stayed there until 2013 when we needed a bigger space for our growing family. We started renting it out in April of 2013. I guess my question is, are any of the closing costs I paid when I purchased in 2005 able to be added to the basis? I'm not sure that I deducted them for my 2005 taxes and don't know how to even tell at this point, it's been too long. I'm grappling with trying to find things I can add to the basis to counteract the depreciation recapture tax.  And do any of the condo fees I paid up until I rented it out count? If the association made upgrades or improvements to the property with them? New pavement...etc? Thanks. 

[HopeS]

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