How to Handle Rental Property Start Up Costs for Taxes

Becoming a landlord involves financial commitments that begin before the first rent check is collected. These initial outlays, from targeting a property until it is ready for a tenant, are known as rental property start-up costs. Properly identifying and categorizing these expenses is a component of accurate tax planning and budgeting for an investment property.

Identifying Pre-Rental Expenditures

Before a rental property can generate income, a landlord will encounter various costs grouped into several categories. The first is acquisition costs, the fees associated with the purchase itself. Beyond the down payment, a buyer will face numerous closing costs, which can include:

• Appraisal fees to determine the property’s value
• Inspection fees for professional assessments of its condition
• Title insurance to protect against ownership disputes
• Legal fees for document review
• Transfer taxes levied by local governments
• Loan origination fees from the mortgage provider

Once acquired, funds are needed for improvements and repairs to make the unit attractive and safe. These can range from major capital improvements, such as a new roof or a complete kitchen remodel, to more minor repairs like fixing a leaky faucet or applying a fresh coat of paint. This category also includes the costs of initial deep cleaning, landscaping, and the purchase and installation of new appliances.

Finally, a new landlord must cover carrying costs during the period after closing but before a tenant begins paying rent. These are the ongoing expenses of property ownership that accrue regardless of occupancy. They include the interest portion of the mortgage payment, property taxes, and premiums for landlord insurance, as well as utility bills to maintain the property.

Tax Treatment of Initial Costs

The Internal Revenue Service has specific rules for costs incurred before a property is rented, requiring landlords to differentiate between expenses that are deducted immediately and those that must be capitalized. This distinction is fundamental to calculating annual taxable rental income.

Costs that are capitalized are added to the property’s cost basis and are not deducted in the year they are paid. Their value is recovered through annual depreciation deductions over the asset’s useful life, which is 27.5 years for residential rental property. In contrast, deductible expenses are subtracted from rental income in the current tax year.

To distinguish between a capitalized improvement and a deductible repair, the IRS uses the “BAR” test, which stands for Betterment, Adaptation, and Restoration. An expense must be capitalized if it results in a betterment that fixes a pre-existing defect or adds to the property’s value. Costs are also capitalized if they adapt the property to a new use or restore it to a like-new condition.

The “placed in service” date dictates when the tax treatment of expenses changes. This is the date the property is ready and available for rent, not necessarily when a tenant moves in. Before this date, costs like repairs, insurance, and utilities are capitalized and added to the property’s basis. Once the property is placed in service, ongoing operational costs become currently deductible rental expenses.

Calculating Your Property’s Basis

Determining the correct initial basis of a rental property is a calculation that forms the foundation for future depreciation deductions. This cost basis represents the total investment in the property that can be recovered through tax deductions. The calculation begins with the property’s contract price.

To this amount, you must add certain settlement or closing costs that were necessary to complete the purchase. These capitalized costs include items like abstract fees, legal fees for document preparation, recording fees, and land surveys. Other additions to basis are transfer taxes and owner’s title insurance premiums.

You must also account for any seller credits that reduce the buyer’s acquisition cost. For instance, if the seller provides a credit for needed repairs discovered during inspection, these amounts would reduce the property’s basis. The goal is to arrive at a figure that reflects the true total cost of acquiring the asset.

For a clear example, consider a property purchased for $300,000. If the buyer also paid $1,500 in legal fees, $500 for a survey, and $2,000 in transfer taxes, these amounts are added to the purchase price. The initial basis for depreciation would be $304,000. This final number is what will be used on Form 4562, Depreciation and Amortization.

Handling Business Organizational Costs

When a rental property is held within a legal entity like an LLC or a partnership, organizational costs for creating the business also arise. These expenses are treated separately from property acquisition costs and are subject to their own tax rules.

Organizational costs are the direct expenses of forming the business entity. Specific examples include state filing fees for registering an LLC, legal fees paid to draft an operating agreement, and accounting fees for setting up the new business’s books. These are expenditures incurred before the business begins operations.

The IRS provides a specific rule for these costs under Section 248 of the Internal Revenue Code. A taxpayer can elect to deduct up to $5,000 of business organizational costs in the first year of business. If the total organizational costs exceed $5,000, the remaining amount must be amortized, or deducted in equal installments, over a 180-month period.

This $5,000 first-year deduction is subject to a limitation. If the total organizational costs exceed $50,000, the initial deduction is reduced on a dollar-for-dollar basis by the amount over $50,000. These organizational costs are never added to the property’s basis for depreciation, reinforcing the need to track them separately.