If a new home owner bought a two family house and tried to rent one of the units and live in the other unit but was unable to, Do you recommend they apply for rental loss using schedule E? If so, What would they put on Rents received, repairs, supplies, utilities and depreciation expenses sections if they never rented one of the units before as a first time home owner. What is the likelihood they would get penalized or audited for using schedule E??
If one of the duplexes was available and advertised as available and ready for rent then the date it was ready and available is the 'date placed in service'. This is the key date when it should be listed on the tax return, regardless if it was actually rented in that tax year.
The depreciation begins in the month it was available for rental purposes, (not when repairs or capital improvements are being done to prepare it to be ready). Repairs, supplies, utilities, insurance property taxes can all be deducted from the date placed in service forward, as you continue to try to rent out the property. You can use the percentage that applies only to the duplex that will be rented for expenses that affect the entire property. You can use 100% of expenses that affect only the rental portion.
Separate the cost of the building by using square feet of the rental unit divided by the total square feet. If both units are identical you can simply split 50/50.
If you rent it for less than fair rental value then expenses and losses would be limited. There is no deduction for renting your property at below market value. In fact, the problem with not renting your property at Fair Rental Value (FRV) is that you aren't allowed to claim a loss if your expenses exceed your income.
[Edited: 04/11/2022 | 12:36p PST]
Thank you Diane, so it’s 100% OK to use schedule E as a new home owner even if I never rented the unit before? I’m only asking because someone warned me against using schedule E. They told me that schedule E can be used for rental loss only if the unit was occupied before and they moved out and couldn’t find a new tenant. But I’m a new home owner and the house was delivered vacant. So I want to do this right without getting audited or penalized.
As long as the rental was available and advertised as available and ready for rent then the date it was ready and available is the 'date placed in service'. This is an accepted practice and won't raise any red flags with the IRS.
Thanks Patti, what is an acceptable proof of advertisement for the rental unit? What happens if I lost or can’t prove the receipts? Is there a penalty or they just simply ask to pay back what I saved?
I highly recommend you list each unit on the SCH E as it's physically separate own property. Assuming both units are someone the same and are 50% of your cost basis for each one, this is usually the best way to go. That way, if you rent out one and live in one, it's so much simpler to deal with on the taxes should things change in the future. For example, if you move out of the one you're living in and start renting it, then you just enter it as a completely new property. Likewise, if you're renting them both out and then later move into one of them as your primary residence, you simple convert that one unit to personal use.
Reporting the property as a multi-plex/multi-family unit creates major headaches when things change in the future.
Now I assume you are a first time landlord. With that, be aware that the TTX program does not provide the clarity it should on a number of important items. When setting up a rental in that first year, absolute perfection is not an option. It's a must. Even the tiniest of mistakes can (and will) grow exponentially over time. Then when you catch the error years down the road (usually in the tax year you sell the property) the cost of fixing it *will* be expensive.
So if you have question, ASK! It's not like you learn this stuff through osmosis. Now for the details and clarifications you will need, which the program really doesn't provide.
Rental Property Dates & Numbers That Matter.
Date of Conversion - If this was your primary residence or 2nd 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.
RENTAL PROPERTY ASSETS, MAINTENANCE/CLEANING/REPAIRS DEFINED
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.
Cleaning & Maintenance
Those expenses incurred to maintain the rental property and its assets in the usable condition the property and/or asset was designed and intended for. Routine cleaning and maintenance expenses are only deductible if they are incurred while the property is classified as a rental. Cleaning and maintenance expenses incurred in the process of preparing the property for rent for the very first time are not deductible.
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.
Additional clarifications: Painting a room does not qualify as a property improvement. While the paint does become “a material part of” the property, from the perspective of a property appraiser, it doesn’t add “real value” to the property.
However, when you do something like convert the garage into a 3rd bedroom for example, making a 2-bedroom house into a 3-bedroom house adds “real value”. Of course, when you convert the garage to a bedroom, you’re going to paint it. But you will include the cost of painting as a part of the property improvement – not an expense separate from it.