Tax question regarding converting primary into a rental

12 Replies

My primary residence will be paid off in less than two years.  At that time, I am going to purchase another primary and rent out my current one.  The house will need new windows and a roof within the next five years, so I am not sure when I will do those yet. Maybe after it is rented and in between leases, or prior to the first rental period when I move out.

To get it "rent ready" I will need to replace a shower insert, some paint, carpet etc prior to renting it out.

Do I have to wait until I move out so I can use those "rent ready" repairs towards any tax write-offs?

Can I start doing them over the next two years while still living in the residence (save the receipts) and state that it was to prepare the rental (which would be factual)?

Thanks BP

There are two kinds of write offs with rentals - depreciation and expenses. Depreciation is basically pro-rating amounts paid over the expected life of the item. Expenses are taken in full the year of the expense, BUT the property must first be in service as a rental to take an expense deduction. And capital items are always supposed to be depreciated.

So until you have it rented, you don't get any expense deductions. Certain improvements made would be added to your cost basis in the property where you could then depreciate those. Replacing all windows is a capital item, so your timing of that won't really change the tax treatment IMO. @Steven Hamilton II , @Charles Perkins , @Bill Walston and Dave NA can perhaps give you more or better info.

@Steve Babiak  

that expense rule is no longer as cut and dried as in the past.  Hopefully, one of the guys you mentioned will weigh in, but this may become a major issue for some RE investors.  

@Bryan N.  

I'm curious why you don't buy another property now while the rates are low?  Unless you are making a lot of extra payments, most of your principal should be paid down now, which would potentially give you plenty of equity towards another property.   

I am pursuing my first rental property at the moment.  Pre-approved loan will be setup today. I'm adding extra payments to this property to pay it off early.  I'm in the military, so if I have to move I want this paid off.  If I don't have to move in the next three years, I will buy another primary and rent this out.  It will be a nice rental and I will use equity from this house to purchase more properties in the future.  

@Steve Babiak  or others who may know, if you cannot take expenses until in service as a rental, what about in an area where a rental permit and inspection is required before renting?  Can I expense charges (plumber, electrician, etc.) preparing for rental inspection after applying for the permit but before the inspection (renters not allowed until inspection)?   I'm hoping "in service" would mean after I've applied and paid the fee as the repairs were to bring it up to rental code inspection ready, more strict than owner-occupied.  

@Bryan N.

As has already been pointed out, there are some make ready items that are capital improvements no matter whether done before or after the property is in service as a rental. In my opinion, a new carpet and a shower insert are capital improvements that are depreciated, never expensed. Does not matter when you do these, the tax treatment is the same.

Painting, is another story. If done before the property is in service as a rental, makes the painting a capital item that increases your tax basis. Placing the property in service as a rental simply means that you are advertising the property as ready and available for rental use. You certainly can begin advertising and showing the property, then do the interior/exterior painting during the time it takes to get a renter in place. In this scenario, the painting is a maintenance item that can be expensed. Most minor repairs that do not detract from the appearance of the property, can also be accomplished during your "listing" period and expensed as maintenance or repair since the property is in service as a rental.

Advertising the property as ready and available for rent does mean that you will have to vacate the property beforehand. Doing the repairs while you are still living in the property (you said you might be there another two years), makes the repairs personal expenses that are not deductible nor is the cost of the repair added to your basis.

I don't know why you are so anxious to have a free and clear property. I would rather keep a mortgage loan in place and let the income from my renter pay off the loan. That way I am not putting money out of my own pocket into equity that I can't use for another investment. Unless you are getting ready to retire soon, and will depend upon the cash flow for living expenses, I don't see that you need to be in a hurry to pay off a rental property as long as the rental generates an acceptable positive cash flow.

If I'm forced to leave the area the rent would bring 1,900 a month.  The mortgage (15yr 3.375) is 2,400 per month.  Either way, I am going to pay it off.  It will only benefit us in the long run and I can afford to do it.  The only debt I find acceptable is mortgage debt.  It wouldn't make sense to refi into a 30 or any term really when I will definitely live here two more years and can zero the mortgage in the process.   I want to do the "rent ready" repairs listed above.  I just don't want to make a bad tax move by timing it wrong.  Maybe it's worthwhile to vacate the property (2yrs from now) and then fix everything and rent.  At least the timeline would be closer to the rental than if I did it this year. 

@Lynn M. here is a link from IRS:

http://www.irs.gov/publications/p527/ch02.html#en_US_2013_publink1000219036

Here is an excerpt from that page:

"You place property in service in a rental activity when it is ready and available for a specific use in that activity."


So the two key words IMO are "ready" and "available". Not so sure you can say it is ready until the property is able to pass an inspection, so ...


@Steve Babiak  , Thanks!  Example 3 on that link helps me understand it more clearly.

@Steve Babiak

It seems the paragraphs below may apply to my situation. The key is to wait until the year it will become a rental.

Conversion to business use. If you place property in service in a personal activity, you cannot claim depreciation. However, if you change the property's use to business or the production of income, you can begin to depreciate it at the time of the change. You place the property in service for business or income-producing use on the date of the change.

Example.

You bought a house and used it as your personal home several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can begin to claim depreciation in the year you converted it to rental property because at that time its use changed to the production of income.

Bryan,

Also beware that converting a primary residence into a rental property carries with it an often overlooked tax trap. Your depreciable basis in the property is the lesser of your original cost basis + cost of improvements prior to conversion or the FMV at the date of conversion.

In other words, if the value of your property has declined while you have owned it, don't expect to use the original cost of the property to determine depreciation. You'll be stuck with the lower value. 

Furthermore, should you subsequently sell the property you will only be able to use the lesser figure of FMV to determine the deductible loss.

The intent of the rule is to prohibit taxpayers from transforming a loss incurred while the property was used for personal reasons, into a deductible loss at a later date. 

Nathaniel Busch, CPA 

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