Schedule E

[Kevin D.]

If my single-member LLC bought a property in 2014, but was not placed up for rental until 2015; so there is no income or expenses (other than capitalized expenses). Do I need to add the property on my Schedule E? It seems that since Schedule E does not have a balance sheet, that I would not be required to list it..

[Linda Weygant]

Here are snippets from the IRS website, Publication 527 - Residential Rental Property:

Placed in Service You place property in service in a rental activity when it is ready and available for a specific use in that activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.

So this means that the property has to be both ready and available for rental.  Putting a sign up before the rehab is finished does not make the property ready or available unless the house is habitable and you are willing and able to finish the rehab during and after tenants move in.  So typically, if you have a situation like this:

2/1/14 - Property Purchased

2/10/14 - Rehab begins

2/28/14 - Sign placed in yard.  Prospective tenants begin walking through but property is not habitable

3/10/14 - Rehab not finished, but house is habitable and you are willing and able to finish the rehab while tenants are living in the house.  I would personally define this as small details needing to be addressed such as paint retouching and other cosmetic issues.

3/15/14 - Tenants move in

3/25/14 - Rehab finished.

In this particular case, your Placed In Service Date is 3/10/14 and you would begin depreciation on this date.

The IRS is notoriously silent on everything that gets added to basis and leaves this up to some amount of interpretation.  It includes a list of examples but this is an area of tax law that is a little bit grey.  For example, the IRS says specifically this:

Cost Basis The basis of property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. Your cost also includes amounts you pay for: Sales tax charged on the purchase (but see Exception next), Freight charges to obtain the property, and Installation and testing charges.

Real property. If you buy real property, such as a building and land, certain fees and other expenses you pay are part of your cost basis in the property. Real estate taxes. If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller does not reimburse you, the taxes you pay are treated as part of your basis in the property. You cannot deduct them as taxes paid. If you reimburse the seller for real estate taxes the seller paid for you, you can usually deduct that amount. Do not include that amount in your basis in the property. Settlement fees and other costs. The following settlement fees and closing costs for buying the property are part of your basis in the property. Abstract fees. Charges for installing utility services. Legal fees. Recording fees. Surveys. Transfer taxes. Title insurance. Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

Adjusted Basis To figure your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service for business or the production of income. The result of these adjustments to the basis is the adjusted basis.  

Increases to basis. You must increase the basis of any property by the cost of all items properly added to a capital account. These include (my edit; but are not limited to...) the following. The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year. Amounts spent after a casualty to restore the damaged property. The cost of extending utility service lines to the property. Legal fees, such as the cost of defending and perfecting title, or settling zoning issues. Additions or improvements. Add to the basis of your property the amount an addition or improvement actually cost you, including any amount you borrowed to make the addition or improvement. This includes all direct costs, such as material and labor, but does not include your own labor. It also includes all expenses related to the addition or improvement.

That sentence in the second to the last paragraph which I've underlined as well as the last sentence which I've also underlined are what cause quite a bit of confusion for people.  Most tax professionals will bring in a portion of the tax code on this that is not specific to rental property but is more general with regard to depreciable business assets in general, which is this:

The basis of the asset is the cost to procure, install and bring the asset into service.

So it's the "bring the asset into service" portion which then causes all kinds of costs to be added to the basis such as utilities during rehab, mortgage or other loan interest, property taxes, legal fees, etc.  

So to sum up....  buying a house that is turnkey or close to would indicate that you would expense things like mortgage interest, utilities etc on the Schedule E pretty much from day one because the property is ready and available for its specific use, even though it's not actually rented yet and may take a while to rent.  It's not the time period of the expenses, it's the condition and intent of the property and property owner.  

However, if the property is not ready and available for its specific use, then the payments associated with bringing it to a ready and available condition would be added to the basis of the property.

So here's a tale of two of my projects that sort of illustrates the differences.

Project A - was technically habitable when I purchased it, except for a rather significant plumbing leak.  However, I intended to do a full gut of the kitchen and both bathrooms, rendering it uninhabitable.  All costs associated with bringing it into condition were added to basis including utilities and mortgage interest during the rehab period as well as more obvious expenses such as materials and labor.  

When the property was ready and available, it still sat vacant for six weeks.  The utilities and mortgage during that six week period were included as expenses on my Schedule E and I began my depreciation period as of the date it was ready and available.

Project B - somewhat turnkey property.  Needed paint, carpet cleaning, closet door repairs, dishwasher repair and a kitchen cabinet repair.  It was habitable upon purchase and remained habitable during the fix up period.  Put a sign in the window the day after closing and began tenant screenings .  Fix up took a month, however, because I was lazy, it was right between Thanksgiving and Christmas, the weather was cold and crappy and I was in a bad mood, among other reasons.  It didn't rent until February 1.  Mortgage interest and all maintenance costs were expensed on Schedule E from day one.  Depreciation also began the day after closing.

TL;dr - taxes are hard.