The quick answer to this question is yes and no. Why both? It depends on whether the property is considered held for investment or held as a business with the intent to generate a profit because deducting rental expenses is directly related to the nature of your endeavor.
Business or Investment When It Comes to Deducting Rental Expenses?
An investment property is one that is held for a profit but which does not have substantial activity involved in the making of that profit. The IRS will, consistently, argue that a property is investment property if the taxpayer owns it for a profit, but the activity is not substantial (frequent, regular, and continuous) – either by the owner or with the help of a manager, agent or others.
Generally, if the rental property is vacant all of the time, the IRS could decide that you are an investor because you did not spend much time dealing with the property. It must be remembered that the IRS has tremendous look-back ability. You may consider their rental effort to be a business, but if the IRS determines that the property was either vacant or sufficient activity was not taken to rent the property, then the property would be considered an investment not allowing you to deduct any expenses on your tax return until the property is sold.
Business property is one that is held for a profit, and there is substantial proof that the activities done in that business were done consistently and regularly. Taxpayers have lost cases that seemed to be straightforward because there wasn’t significant activity. In one court opinion, the taxpayer inherited property from his mother. The property had been rented out for many years to the same tenant. The same tenant rented the property until the taxpayer sold the property 14 years later. The taxpayer managed the property himself or with the help of an agent the entire time. Little management work was required, but the taxpayer took care of such details as replacing the furnace. The IRS and court found that the house was an investment and not a business for the taxpayer. The court noted that this was the only rental property ever owned by the taxpayer and concluded that his landlord activities were too minimal to rise to the level of a business. The Internal Revenue Service and the courts look at whether the activities involved are substantial, frequent, regular, and continuous. If the determination is that the activities do not meet these criteria, the property is considered held for investment, in which case deducting rental expenses is not allowed. The lesson to be learned is although renting even a single unit can be a business, the taxpayer could have trouble showing the management activities are sufficiently continuous, systematic, and regular.
Generally, if the rental property is vacant all of the time, the IRS could decide that the taxpayer is an investor because they wouldn’t need to spend much time dealing with the property. It must be remembered that the IRS has tremendous look-back ability. The taxpayer may consider their rental effort to be a business, but if the IRS determines that the property was either vacant or sufficient activity was not taken to rent the property, then the property would be considered an investment, not allowing losses to reduce their regular income until the property is sold.
It Is a Business – Start-Up Costs
When you go into business, you should treat all the costs you had to get your business started as capital expenses. Usually, you recover costs for a particular asset through depreciation. However, taxpayers can elect to deduct up to $5,000 of organizational costs paid or incurred after September 8, 2008. The $5,000 deduction is reduced by the amount the total start-up or organizational costs exceed $50,000. Start-up costs include any amount paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational costs include the costs of creating a corporation or partnership. To be considered a start-up cost it must be a cost that you could deduct if you paid or incurred it to operate an existing active trade or business, and it is a cost you pay or incur before the day your active trade or business begins. Some examples of start-up costs would be advertising to find a renter, doing credit checks on potential renters, hiring a manager to manage the property (ensuring that manager keeps good records of times spent on your property). Start-up costs do not include deductible interest, taxes, or expenditures to make improvements to the property.
Tax Planning Considerations
George Birrell, a CPA at the virtual tax prep firm that specializes in helping small landlords optimize their tax savings, Taxhub recommends that If you are not going to be profitable in your first year, you may want to consider another option to minimize your taxes in years where you make more profit. Instead of deducting $5,000 in your first year, you may amortize all start-up costs over 15 years, taking the same deduction each year. For example, if your start-up costs are $45,000, you could deduct $3,000 a year for 15 years.
You elect to deduct the start-up or organizational costs by claiming the deduction on your income tax return for the tax year in which the active trade or business begins. The expenses that aren’t currently deducted can be amortized over 180 months. The amortization period starts with the month you begin operating your active trade or business. Once made, the election to either amortize or capitalize start-up costs is irrevocable and applies to all start-up costs that are related to the trade or business. To learn more about deducting rental expenses and similar concerns, get a free consultation or get pricing on our virtual tax prep services.