Room for Interpretation in Tax Laws ?

Question

I've been doing a lot of research on rental property tax accounting the past few days and am amazed (frustrated) at how many different answers I'm finding. For example:

1. Pre-rental expenses. On the one hand, some say nothing is deductible as an expense, but must be capitalized. But then I also read that fire insurance premiums should not be added to cost basis so what happens to pre-rental insurance expenses?

Others say you can consider the property as available for rent if you were willing to rent it "as is" on day 1, even if you are not actively advertising.

2. Should systems like HVAC be expensed or depreciated? Again, it depends on who you ask. Some say there are situations where you can claim it as an expense while others say you must always depreciate it.

So my question is, are these rules open to interpretation? Or should they be black and white and some guys are simply wrong?

And if you have an accountant that is shall we say "aggressive," what happens with IRS audits and the statute of limitations? Decisions on expensing vs depreciating will affect tax returns for many years to come. If the statute of limitations on audits is 3 years, what happens with incorrect decisions made more than 3 years ago but have had a carryforward effect?

Steven Hamilton II · Answer

@Paul C,

Black and white.

1. Pre rental expenses must all be capitalized. That would include the insurance, utilities, etc. The only items that can be deducted are property taxes on Schedule A and occasionally interest on Form 4952.

The property must be available and ready for rent. I.e. move in condition. It also means that you must be actively attempting to find a tenant.

2. They MUST be depreciated. The only exception is repairs/ maintenance unless it becomes a substantial cost in which case it may be required to be depreciated if you are replacing significant portions.

And if you have an accountant that is shall we say "aggressive," what happens with IRS audits and the statute of limitations? Decisions on expensing vs depreciating will affect tax returns for many years to come. If the statute of limitations on audits is 3 years, what happens with incorrect decisions made more than 3 years ago but have had a carryforward effect?

There is nothing wrong with being aggressive; however, there is a blatant disregard of the law in which they could be help liable if you file a claim against their E&O or sue them for malpractice.

That would depend upon the degree of the change. If there was no change, you simply make an accounting change to adjust it properly by filing Form 3115

Bill Gulley summed it up; however, I will say that bracket is probably an immaterial cost and would be expensed due to the low cost.

There are certain records that should be maintained indefinitely, purchase and sale of property and significant basis repairs/updates.

Brian Mathews · Answer

If you are managing your accountant, you need a new accountant. That's what you pay them for. They should know the answers to all your questions and if they don't, then they need to find out. That's why they are a CPA.

David Beard · Answer

Most of this follows a certain logic.

1) Whatever you read about insurance was taken out of context. All expenses incurred on the property prior to making it available to rent (as evidenced by an advertisement, not a nebulous contention that your were willing to rent it "as is", that's rather ridiculous, wouldn't want to sell that to an IRS auditor), are to be capitalized and depreciated. This includes carrying costs during the rehab stage: insurance, property taxes, lawn care, utilities, etc.)

2) A new HVAC system? Always depreciated, there is no wiggle room here. If it is simply overhauled or repaired, then that can be expensed. I've become pretty conservative on these things in order to keep my taxable income higher, which helps your debt ratios and makes you look more successful when pursuing bank financing. In the long scheme of things, this is worth more than the short term bucks you'll get from the tax deductions (which also might put you in an awkward spot should you get audited, coughing up taxes and penalties).

3) While there is no statute of limitations on maintaining all records to establish the correct basis on a property (for computing depreciation currently abd eventually computing the capital gain when disposed of), I do think that you would have something of a "safe harbor" if something that you expensed improperly (or let's just say aggressively) has slipped more than 3 years into the rear view mirror, as long as there is no evidence of fraud/criminal activity or other shenanigans that would give the IRS greater leeway in dredging things up. I would like to hear Steven Hamilton II's opinion on this item.

Bill Gulley · Answer

I'm sure Steven will come in, but if I purchase a property as an investment, it goes "in service" the day I buy it. Expenses are being suffered the day I buy it, not the day I rent it.

Your are incurring tax liabilities from day one, you have insurance expenses from day one, that bottle of Mr. Clean was used on the property before you rented it but after you bought it, it's an expense on that property.

Paint, that can fall in either category, if the whole house is painted and contributes to a longer economical life of the property and it's use, amortize the cost, if you just painted the trim at a minimal cost you can expense that.

Cleaning units will always be an expense, cleaning supplies and disposable items like a sponge, they don't extend the life of the property but are done to market the property.

The key is in extending the economical and financial life of an earning asset. If I ran a ferry moving vehicles across a river and had to refit new or rebuilt engines, I'd need to amortize that cost as it extends the useful life of my asset.

My example of a furnace filter holder probably was not a good one, if it's a minor cost and the useful life can't really be determined that repair could well be an expense. But a new HVAC system is a capital improvement, not an expense. If I had a $1,200 gas burner replaced in my existing furnace that will extend the life of the unit and should be capitalized, not expensed. Getting the furnace cleaned is expensed as it's a minor amount and while it may improve the life, it does not warrant saying that it extends the life by a period of time.

I'm sure Steve will be here, I'll stop. :)

Wayne Brooks · Answer

capitalized

@Steven Hamilton II

?

Brie Schmidt · Answer

the book references that situation but off the top of my head I don't remember. I can look at my book later tonight when I get home.

Paul C. · Answer

@Brianna Schmidt thanks. I think I'll get that book, not because I want to do my own taxes, but so that I can manage my accountant. I was not referring to OO properties that were converted, but newly acquired investment properties bought for the purpose of being a rental. For example, let's say I close on a property on February 1. I then incur costs painting and cleaning the property in the month of February. On March 1, I drop the keys off to my property manager who then begins actively seeking a tenant. Would the painting and cleaning expenses incurred in February be deductible as an expense or would they need to be added to the cost basis of the property and capitalized? I have heard both answers from different CPAs.

Brie Schmidt · Answer

are you referencing a property that was OO and converted to a rental? If so, nothing prior to the conversion is counted as an expense. A repair to HVAC is considered a deduction in the current year and a new system is depreciated. I recommend this book if you are looking to DIY your taxes

http://www.amazon.com/Every-Landlord%C2%92s-Tax-Deduction-Guide/dp/1413319270/ref=sr_1_1?ie=UTF8&qid=1386624884&sr=8-1&keywords=landlord+tax+deduction+guide

Bill Gulley · Answer

I suggest you just look for a good tax guy and not so much of an aggressive tax guy or one with little experience. There is no statute of limitations on tax fraud, if you're expensing off HVAC and other repairs required to be amortized, and did so for years they might say you acted intentionally.

A new bracket fitted to hold a filter on a furnace is an attached improvement. A furnace filter is an expendable part that may be expensed.

The nature of expenses are usually those that have a short life, are expendable, used and thrown away like a mop head and cleaning supplies, office supplies.

Insurance is an expense in holding a property from day one, it is not part of the property, nor are taxes or HOA fees, your city license.

These differences are found in Financial Accounting Standards Board (FASB) rulings with respect to generally accepted accounting practices (GAAP) as well as the Code setting schedules. A small business is not required to adopt GAAP, but what the IRS requires if such accounting practices are not followed is any system which accurately illustrates the business transacted and done so in a consistent manner. This attitude was adopted way before computers and accounting software was available, so since the adoption of GAAP is now at such a low level and at a lower barrier to the use of a decent accounting system, I'd suspect any IRS examiner will not be happy looking through your shoe boxes that are color coded as your system.

I suggest you get with a bookkeeper who can help with a "chart of accounts" for your business, get an accounting program and set up your system.

It will pay you to become familiar with basic accounting and the concept of expenses, depreciation, income, assets and net worth. You'll find that there is little interpretation involved in RE accounting for landlords. :)

Wayne Brooks · Answer

You're not really getting conflicting advice, your talking about different categories of expenses. Items like insurance, utilities and property taxes have nothing to do with property improvements, and are deductible as paid. Improvement/repairs to get it rent ready add to the basis. Get "aggressive" at your own risk.

Room for Interpretation in Tax Laws ?

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