Rehab costs - add to basis or take loss that year?

Question

When you purchase a property and immediately rehab before renting out, do you add the cost of the rehab to your basis of the property, or do you take a loss that year? Does it make a difference if you have a bunch of small receipts from the rehab vs one large bill from a GC?

I spent 7k on a rehab, which my CPA added to losses for this year. Unfortunately there is a Passive Activity Loss Limitation (form 8582) and it didn't add anything to the losses I was already taking because of the limitation. I feel like my CPA should've added that 7k to the basis so I could at least depreciate it over 27.5 years and also so I don't pay taxes on gains on that amount if I sell before 27.5 years...

Linda Weygant · Answer

Regardless of whether your business is dependent on financing, tax rules should be followed. Those rules indicate that if the property is rehabbed before being put into service, the rehab expenses should be added to the basis. If, however, you were able to advertise the property for rent and show it because the rehab was minimal, then the property was technically in service and, depending on the nature of the rehab, may have been properly classified as repairs.

It all depends on facts and circumstances, which your CPA should have got a clear understanding of before proceeding.

Linda Weygant · Answer

She's half right.

Yes, it's true that you can fully expense an item that would normally be capitalized if it's less than $2500.  There are a ton of qualifiers to that, but we'll keep it simple for the moment.

She's also correct that you can carry forward the losses to use against passive income gains in the future.

Where she is not correct is that you can only fully expense those items (it's called De Minimus Safe Harbor Rules if you want to get technical) AFTER the property is placed into service.  In your situation, where the expenses were incurred BEFORE the property is placed into service, then they almost always have to be capitalized.

That's the technical answer.

Realistically, if we're talking about less than $2500, then there are some facts and circumstances where, if true, it's fine to handle it like she did.

So let's say you bought the place on August 1 and you immediately put up a for rent sign and placed an ad.  This property is now technically in service because it is habitable and you are ready to show the place and get it rented out as soon as possible.  However, you know that it's going to take at least 2-3 weeks to get a good tenant, so while you're going through the process, you decide to put in new carpet or paint a couple of rooms or put in some new countertops.  You're still showing the place and there is nothing that you're working on that makes it uninhabitable.  If you accepted a tenant on one day, there would be no reason they could not move in the next (barring finishing installing the countertop or letting the paint dry).

If this is your scenario, then it's fine to handle it like she did.

If, however, you've got a house and the toilet doesn't work or the water coming in isn't potable or the electrical panel is shot, the house is not habitable.  You could not put a tenant in it.  So you have to put that $2500 in to fix the toilet or the plumbing or replace the electrical panel.  The house cannot be "in service", so all of the expenses going towards making it habitable and putting it in service are capitalized.  This is also the case if the house is technically habitable, but the remodeling you are doing is so extensive that you cannot show the property to tenants or they could not move in the next day while you finish up little things.

If this is your scenario, then the costs must be capitalized.

When we were first discussing this, I didn't realize the dollar amount was so small.

It's all about facts and circumstances.

Steven Hamilton II · Answer

@Linda Weygant is correct. Anything before the property is ready and available for rent is capitalized and added to basis.

Clay W. · Answer

I just acquired my first investment property – a duplex. One of the tenants in occupancy for decades is a hoarder. I will be submitting to them a "60 days notice to vacate." I don’t know ultimately what will be discovered once everything is removed from the unit because the inspector could not complete a full walk-through during escrow. However, there will clearly be cleaning costs and rehab work for visible damage noted during inspections.

Because there is technically a "tenant" in place now, but the unit is in no way habitable/rent-able until fixed up, how will those investment dollars be reflected  -  i.e. applied to the basis or deducted at once?

Steven Hamilton II · Answer

If you need a few referrals let us know.

Matt John · Answer

1) Thanks for the help! @Linda Weygant and @Steven Hamilton II were both right on.

2) I will not being using the same CPA next year. She obviously doesn't know real estate is isn't aggressive in trying to save me money.

3) @Michael Seeker - I bought it in Sept and rehabbed through the first half of Nov. I had it rented by Dec 1st, so only got 1 month of rent. 1 month of rent did not offset the deducted rehab, so it definitely looked like a loss the way she originally worked it up. We will be changing that before filing.

4) I did a little light reading last night from IRS Publication 527 and IRS Publication 535. Based on what I read it seems like there's a very small grey area where you may be showing your house and still doing minor repairs that can be deducted that year, or you could wait to show and include all of those in your basis. If you are just starting out and have Passive Activity Loss Limitations like I do, you may prefer to have those costs in the basis. If you have positive cash flow from other properties it might be advantageous to deduct whatever costs you can justify in the current year because of the time value of money. Here's what I found that I felt was applicable:

IRS publication 527 says:

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 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.

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.

IRS publication 535 says:

Carrying Charges

Carrying charges include the taxes and interest you pay to carry or develop real property or to carry, transport, or install personal property. Certain carrying charges must be capitalized under the uniform capitalization rules. (For information on capitalization of interest, see chapter 4.) You can elect to capitalize carrying charges not subject to the uniform capitalization rules, but only if they are otherwise deductible.

You can elect to capitalize carrying charges separately for each project you have and for each type of carrying charge.

Then under the Repair and Maintenance Costs section a little further down on the same publication:

Repair and Maintenance Costs

Generally, you can deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized. However, you may elect to capitalize amounts paid for repair and maintenance consistent with the treatment on your books and records. If you make this election, it applies to all amounts paid for repair and maintenance to tangible property that you treat as capital expenditures on your books and records for the tax year.

How to make the election. To make the election to treat repairs and maintenance as capital expenditures, attach a statement titled “Section 1.263(a)­3(n) Election” to your timely filed return (including extensions). For more information on what to include in the statement, see Regulations section 1.263(a)­3(n).

Michael Seeker · Answer

@Matt John - if your business is at all dependent on financing, then your best bet is to capitalize rehab expenses and depreciate over the respective period.  When a lender looks at your past tax records and sees a major loss 2 or 3 years in a row, it's almost impossible to convince them that your properties actually make money and to give you credit for that during the underwriting process.

There are rules about what you can expense and what you need to capitalize, however I'm not an expert on that and would point you to the pertinent IRS literature.  It's been several years since I've had a reno small enough that it could go either way, but I recall at the time searching for the appropriate tax forms and reading through the information provided by IRS.  It is much easier to read that I would have expected and not that difficult to figure out if you take a little time to read through it.

Rehab costs - add to basis or take loss that year?

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