Deducting cost of repairs for new rental house

[Russ Roslewski]

Help, I am a little confused.

We just moved out of town in November and rented our house out starting at the end of the month. So it will have been rented out for about 5 weeks of the year, with a total rental income for the year of about $1400.

In order to rent the house, we had to repair the driveway to the tune of about $5000. I have been reading through Pub 527 but can't figure out if I can deduct from my rental income the whole $5000 (and if I can carry over the remaining $3600 into the next tax year), OR if I can only deduct about 9% of the $5000 since we lived in the house about 91% of the year.

Anywhere I can look for guidance?

(Yes, I am trying to find an accountant but we're new in town.)

Thanks,
Russ

[Jon Holdman]

First, if you don't have a CPA, now's the time to get one. Like Jason, I'm not a CPA. Further, the primary residence converted to rental has more complex tax considerations than either residences or rentals by themselves.

In general, repairs required to make a property ready to rent aren't deductible at all. Rather, they go to increase your basis. On a pure rental, your basis starts at the price you pay, plus purchase related costs. If you make repairs, those add onto the basis. Then, you can start depreciating the property based on the part of the basis that is the improvements (that is, not the land) over 27.5 years. Most individual items have faster depreciation schedules, and, if you wish to separate those components and use the faster schedule, you can.

Neglecting faster depreciation for individual components, you get to take a depreciation deduction of 1/27.5 of the value of the improvements each year. Since you only rented the house five weeks, you'll only get five weeks of depreciation, or 5/52 * 1/27.5 of the value of the improvements. The amount of depreciation (along with operating expenses and interest payments) can be deducted from the actual rents received to get your taxable income.

As you take this depreciation, the basis is reduced. That is, after 10 years (for example), you will have taken 10/27.5 of the value of the improvements as depreciation. (Or, you should have. For this calculation it doesn't actually matter if you did or not.) So, the basis is reduced by that amount. When you sell, the gain on the sale is the selling price, less the selling costs, less the basis. Because the basis is going down because of depreciation, your gain is going up, even if the value of the house is flat. Note that the amount to pay off any loans is irrelevant to this calculation. So, if you've refinanced and have a big note to pay off, you might have only a little cash in hand. That's not the gain, and Uncle Sam will want the full amount of the taxes on the gain, even if the cash you have in hand is less than the gain or even if its less than the taxes due.

Further, you'll pay "depreciation recapture tax" on the amount of the gain up to the amount of depreciation taken (or, that should have been taken if it was not.) That's currently at 25%, vs. 15% for long term capital gains.

Yet further, when you sell a primary residence that you occupied for at least two of the five years prior to the sale, up to $500K for a couple (you said "we") of gain is excluded from taxes. If you rent for longer than three years, and you do have such a gain, you lose that exclusion. I think. Not a CPA, haven't dealt with these residence to rental conversion issues.