Buy and Hold tax deductions

[John Khadiyev]

I am in a process of buying a property to rent it out. I know that the cost of bringing the house to habitable conditions is only deductible when you sell the property. But since you can deduct property maintenance every year. what is the rule and where does cost of updating property between tenants and updating property before tenants make a difference in tax deductions. What counts as maintanence cost? carpet, paint, broken sprinkler head, a new driveway?
The property I am buying needs about $12k in repair and I want to know if I can deduct it this year legally. Or I can't until I sell the house. I do not plan to sell it for a very long time.
Hope this makes sense.

Thank you
John

[Account Closed]

Something are very clearly improvements and must be added to the basis of your property. Meaning that you get to depreciate them over its life. When you sell the property there will be deprecation recapture.

Other things are very clearly maintenance and repair costs. Painting, fixing a hole in the drywall where there is no door stop.

Somethings are more gray. Repairing a roof could be repairs and maintenance depends on the extent and/or if you change the roofing materials. Upgrading the roofing materials would be considered a betterment or an improvement and would have to be depreciated. Putting on a new layer of shingles could be considered a repair rather than an improvement.

The basic idea of improvements is that it adds to the life of the building.

[John Khadiyev]

Thank you for the response Charles.
So to be more specific. This house has a pool that has caved in because it was drained all the way down and collapsed in. Repairing the pool is not an option, would cost too much, plus I don't want a rental with a pool anyway. Removing the pool will cost approximately $7k do you think its maintenance or improvement?

Thank you
John

[Bryan Hancock]

Do whatever Charles or your accountant says, but it pays to be aggressive with your accounting in MOST instances. I would argue this is a repair and expense it.

[Account Closed]

Originally posted by John Khadiyev:

Thank you for the response Charles.
So to be more specific. This house has a pool that has caved in because it was drained all the way down and collapsed in. Repairing the pool is not an option, would cost too much, plus I don't want a rental with a pool anyway. Removing the pool will cost approximately $7k do you think its maintenance or improvement?

Thank you
John

This would be a clear case of repairs and maintenance.

[Dave Toelkes]

Even though some items may seem like repairs, you can't expense anything done before the property is placed in service as a rental. Repairs needed to make the property ready for rental service are still capitalized and depreciated.

The IRS will consider extensive repairs as components of an improvement project.

In my opinion, filling in the pool is a major landscaping improvement not a repair

[Account Closed]

Dave, this is true. Depreciation starts at the time a property is put in service.

Any business expenses incurred prior to going into business would be treated as start-up or organization costs and would amortized.

John, you can make a sound argument that filling in the pool is a repair. Like Dave said though since this is being done before the property is actually being placed in service it would have to be amortized as a start-up cost. In many cases you can write-off your start-up costs in the first year of operation.

[Bill Walston]

Originally posted by Dave T:

In my opinion, filling in the pool is a major landscaping improvement not a repair

As much as I FAVOR Charles' idea that this is a "repairs and maintenance" item, my experience has been in line with Dave's. Since the property is being readied for rental use, Uncle Sam would expect that this be treated as a capital expenditure and included with land improvements.

[Account Closed]

Capital Expenditures are defined as expenses that add to the value or useful life to a property.

Repairs are expenses that keep property in an ordinary efficient operating condition and do not add to its value or appreciably prolong its useful life.

Land improvements are those betterments, improvements and site preparations that ready land for its intended use. Like land these improvements are inexhaustible and therefore not depreciated. Examples of land improvements include excavation, filling, grading, demolition of existing buildings, and removal or relocation of other property.

There are several choices here. I would reiterate that filling in a swimming pool adds no value and certainly doesn't extend the life of the property. I see no way of classifying this asset as a capital improvement. I would be interested in arguments that support that idea.

Some might call this a land improvement. Generally speaking though land improvements make a property ready to use for the purpose of building a structure. In this case the land is being used for its intended purpose. I would not call this a land improvement either.

IMO again, there is good reason to say that you are bringing the property back to its ordinary and efficient operating condition.

I'm sure that I can go beyond the definitions and site some regs to prove this point.

I think some IRS agents might try to show this was a nondepreciable land improvement, but I think that could be refuted fairly easily.

[Bryan Hancock]

To me this is one of the cases where you are aggressive because the probability tables show that this is the most favorable risk-adjusted path to take. I would lobby for expensing this if it was my return.

Charles...I thought the concept of depreciation was to allocate expenses to the year they produce income and not to "exhaust" the use of the property. Is this a point where tax accounting and financial accounting diverge?

[Account Closed]

There are some long term assets that are considered not to get used up over time(in other words they are inexhaustible). Land and some land improvements are one.

There are improvements to land that are depreciable, walkways, retaining walls, shrubbery, driveway, fencing, etc these all have a useful life and will deteriorate over time.

Tax accounting and financial accounting do diverge when it comes to depreciation. The concept of "matching" is a financial accounting concept not found in the tax code. Financial accounting advocates attempting to match revenue with the expenses (also called the accrual method) used to create the revenue. So a depreciation method that more closely matches how assets are used up would be preferred in financial accounting. Also in financial accounting the principle of conservatism comes into play. Tax accounting uses accelerated methods over shorter useful lives than what would generally be used in financial accounting. Judgment is a key ingredient her though so in no way is a blanket treatment suitable for all companies.

[John Khadiyev]

So the day escrow closes I put a FOR RENT sign on front lawn. Would that count as placed in service? I know its splitting hairs and probably wont matter, so I'm just wondering.

Thank you
John

[Dave Toelkes]

John,

The day that the property is READY and AVAILABLE for rental use is the date the property is placed in service.

Charles,

The startup cost amortization you refer to applies to an active income business. What we have under discussion is a passiive income rental activity. The rehab necessary to make a property ready for rental use is not an amortizable start up cost, but rather a capital expense that is an adjustment to basis and recovered through depreciation.

That is why the question of whether the pool work is a repair or improvement is moot. It is work done before the property is placed in service, and therefore is still capitalized. I would call the pool project a landscaping improvement and depreciate it over 15 years rather than including it in the building structure depreciation basis and use a 27.5 year recovery schedule.

[Account Closed]

Dave, I agree that many are RE investors rather than in the business of RE. I encourage my clients to actually be in business. There are deductions unavailable to those that are not actually in the business of real estate.

I agree that if this is investment activity, rather than business activity, costs prior to putting the property in service could only be capitalized. The true nature of the costs would be immaterial.

On the other hand if this is a RE business, a good case can be made these are repair costs that would be treated as startup costs.

It is necessary to know all of the facts to make a full determination.

[Bryan Hancock]

Isn't tax law maddening?! Two very well educated and experienced advisors disagree about how to interpret this!

I still say it pays to be aggressive. I don't see how someone could argue reasonably that this wasn't needed as a repair and thus should be eligible for expensing. I understand the "rules" about placing in service, but aren't there other rules about expensing repairs?

[Dave Toelkes]

Bryan,

Actually, Charles and I both agree that the repairs and renovation cost to make your investment rental property ready and available for rental use are capital costs that are depreciated. The question about whether the expense is a repair or an improvement is moot if the property is not yet in service as a rental -- the tax treatment is the same.

Yes, there are costs in establishing, equipping, furnishing, supplying, and staffing a business that could be considered startup costs. But in the scenario where the property in question is being acquired for investment rental use, I can't envision how the work to cover up the pool can be a business start up cost even for a property management business,

[Account Closed]

This is a situation that I would want any of my clients to bring to my attention ahead of time. Timing is important because it can change the nature of a transaction. The existence of an active business could alter the nature of this transaction.