How to treat non-point mortgage acquisition costs when converting home to rental?

[small_taxpayer]

I purchased a property for personal use in 2018 and converted it to rental use in 2019. I also refinanced it in 2019, after we began renting it out. I'm now trying to figure out how to treat the various property and mortgage costs, especially the non-points acquisition costs for the original mortgage. Below I lay out my general understanding, with some particular questions embedded. If you can help with the questions or confirm/contradict the general points, that would be much appreciated!

Home purchase costs (home itself, title-related fees, recording fees, etc.)

These are added to TurboTax as an asset and non-land value is depreciated over 27.5 years. (I assume I just record the original purchase cost and depreciation starts from the purchase date, but maybe I record the value on the date of conversion to rental and depreciation starts then? I'm not too worried about this, since it's easy to enter into TurboTax and let it sort it out.)

Mortgage points (original mortgage)

These were deducted (or at least deductible) on my personal income tax in 2018, so they should not be included in the rental property calculations at all. These include items identified as "points" or "loan origination fee" on the escrow statement.

Loan origination costs (original mortgage)

This includes all costs to acquire the mortgage except points, e.g., appraisal, credit report, lender's title insurance. These were not deductible on my personal income tax in 2018. If the property had been placed into rental use in 2018, they would be recorded as an asset and amortized over the life of the loan (30 years). But I didn't convert it to rental use until later. So this is my main question: when I convert the property to a rental, can I create an asset representing these costs and amortize them? This follows the idea that these costs go with the loan and are always amortized over its life, but the amortization is not tax deductible while the loan is used for a residence and becomes deductible when the loan is converted to being used for a rental property. And in that case, would I deduct the unamortized part as an expense when this loan is paid off (below)? Or instead, should these costs just be treated as non-deductible expenses for the personal home loan, that disappear in the year the loan is taken out?

Mortgage points and loan origination costs (refinance, different lender)

Since the refinanced loan was used for a rental property, all the points and other costs associated with the new loan are amortized over the life of the loan (by creating an intangible asset associated with the rental property).

Does this seem basically right? And again, my main question is, how should I treat the non-points costs of a mortgage that I first took out while I was living in the property, which I then converted to rental use and then refinanced? Should I just ignore these costs, since they were a non-deductible expense in the year the house was bought? Or should I amortize them over the life of the loan, treating the amortization as a non-deductible costs while I lived in the home, but then deducting it after I convert the home to a rental? And in the latter case, should I then deduct the unamortized part as an expense in the year when I refinanced?

Thanks for any help you can give!

[Carl]

You only got one thing wrong that I can find. Depreciation starts on the date the property is placed "in service", which is typically the day you put the "for rent" sign in the front yard. It has nothing what-so-ever to do with the date of purchase/acquisition.

While the program will walk you through this process, there are some screens that in my personal opinion, don't provide the clarity I believe they should. So the below is provided to assist you with that. When dealing with rental property, absolute perfection in that first year 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 the year you sell the property) the cost of fixing it will be expensive.  So if you have questions after reviewing the below and while working it through the program, by all means please ask. Or you can review IRS Publication 527 yourself at https://www.irs.gov/pub/irs-pdf/p527.pdf

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.

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 3^rd 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.

ENTERING POINTS

here's how to enter the points in the Assets/Depreciation section.. (does not apply to entering the property itself, or any other property assets.)
- Select the Add and Asset button. (go straight to the asset summary if presented that option)
- Select Intangibles/Other Property, then continue.
- Select Amortizable Intangibles, then continue.
- Describe it as something like "2021 Financing Fees".  Then enter the amount, and the closing date of the loan. Then continue.
- Select "purchased new", then "100% business use", enter the closing date of the loan (again), then continue.
- Code section is 163:Loan Fees, then continue.
- Useful Life in Years is the length of the loan, then continue.
- You can "show details" if you like. Then continue, and that does it

DEDUCT FINANCING FEES OF OLD LOAN WHEN REFINANCING OR SELLING

In the Assets/Depreciation section for that rental property, elect to edit/update the entry for your points.

- On the "Review Information" screen click Continue.

- On the "Did you stop using this asset 2021?" screen, click YES.

- On the "Disposition Information" screen, in the disposition date box enter the date you closed on the new loan. Then click Continue.

 - On the "Special Handling Required?" screen, click YES.

- On the "Depreciation Deduction Amount" screen, select Transfer These Fees For Me To Other Expenses. Then click Continue.

You'll see the remaining fees of the old loan to be deducted in the Rental Expenses section, very last screen of that section. The entry will start with "Unrealized Refinancing Fees...."

[small_taxpayer]

Thanks, this is very helpful!

Just to confirm on one question: How should I treat the non-points costs of the original mortgage, that I took out before I converted the property? Should I amortize them over the life of the loan, treating the amortization as a non-deductible cost while I lived in the home, but then deducting it after I convert the home to a rental? And if I amortize it after the property was converted to rental, should I then deduct the remaining unamortized part as an expense in the year when I refinanced?

I'm having trouble wrapping my head around the last part. Since I "used" the loan partly for personal use (my own home) and later for business use (home converted to rental), do all these costs become a business expense when I pay off the mortgage? Or should I prorate it based on how long the loan was for personal vs. business use?

[Carl]

The last time I converted a property from personal to rental use was back in 2003. So it's been awhile and quite a few of the tax laws have changed since that time.

Your original loan was a standard home mortgage, whereas the refi was an investment property mortgage - assuming you were honest with the lender of course.

For the original loan, your points were fully deductible in the tax year you obtained the loan, as a SCH A itemized deduction. Per IRS Tax Topic 504 at https://www.irs.gov/taxtopics/tc504 :

You can deduct the points in full in the year you pay them, if you meet all the following requirements:

1. Your main home secures your loan (your main home is the one you live in most of the time).
2. Paying points is an established business practice in the area where the loan was made.
3. The points paid weren't more than the amount generally charged in that area.
4. You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them.
5. The points paid weren't for items that are usually listed separately on the settlement sheet such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
6. The funds you provided at or before closing, including any points the seller paid, were at least as much as the points charged. You can't have borrowed the funds from your lender or mortgage broker in order to pay the points.
7. You use your loan to buy or build your main home.
8. The points were computed as a percentage of the principal amount of the mortgage, and
9. The amount shows clearly as points on your settlement statement.

If you satisfied the above 9 items when you took out the original loan, the points were fully deductible in the tax year you got that loan. If you do not meet all the above 9 items, then your points "may" have been deductible over the life of the loan. So if you don't meet all 9 items above, you'll have to check publication 936 at https://www.irs.gov/pub/irs-pdf/p936.pdf to confirm you qualified to deduct them ratably.

While I can't find anything addressing the issue directly in IRS Pub 936 at https://www.irs.gov/pub/irs-pdf/p936.pdf, my understanding (which I am not betting my first born on) is that if you qualified, but did not claim/deduct them in the tax year the loan originated, you can't deduct them now either in full or ratably. If my understanding is wrong, I'm confident someone else will jump into this thread and point us both to the relevant publication or statute.

[small_taxpayer]

Thanks for your help on this. I'm actually wondering how to treat the non-points costs from the first loan, e.g., appraisal fees, lender's title insurance, etc.? Should I amortize them over the life of the loan, treating the amortization as a non-deductible cost while I lived in the home, but then deducting it after I convert the home to a rental? Or should I just ignore them completely? And if I amortize these costs from the original loan after the property was converted to rental, should I then deduct the remaining unamortized part as an expense in the year when I refinanced?

[Carl]

If I recall correctly (it's been awhile for me) I do believe the program will walk you through it all if you use the default step-by-step mode of entering data and setting this up.