1st year for rental home - could use help please

[Small Biz Owner]

Depreciation amount % is in your federal tax return & maybe your state tax return also. Yes for costs associated with your rental. Repairs etc are all deductible.

[Gardening Grandma]

I'm responding only to the first question. If you look at your property tax assessment, it should show the assessed value of the land and the "improvements" (that would be the house)

[taxref]

For your first question, you are correct that land cannot be depreciated. Consequently, you do need to separate those values. There are several ways to do this.

As Gardeninggrandma noted, property tax assessments often have that breakout. While the actual dollar amounts will rarely match what was paid, you can allocate the value based on those percentages. An even better way is to ask for a letter from your real estate agent telling what the value of the lot alone would have been at the time of purchase.

As far as the closing costs are concerned, they are not deductible. Such costs are added to your basis in the property, and are depreciated.

[mwcpa]

"Such costs are added to your basis in the property, and are depreciated"

but you need to allocate those costs to the land the building....

so, purchase price was 500K, closing costs (excluding deposits, actual real estate taxes reimbursed to the seller, etc) of 20K, means the entire purchase price is 520K. If the tax assessors bill (as noted by grandma) or if there is a qualified opinion on the land versus building value on the date of purchase (as noted by ref) was 20% land and 80% building, then 20% of the 520K is land and generally not depreciated...

[TheOtherMe]

I'm retired from the IRS as an agent and the land/building percentage is what we used unless the taxpayer presented something better. There were so many preparers in our area that always put in the same $ amount for land, that we made lots of changes to the amount that could be depreciated.

[cpadvisor]

What about cost segregation? I'm assuming some of the other professionals out there do this?

There is a more extensive list, but...

landscaping, driveways, carpeting, appliances, etc....

[mwcpa]

"What about cost segregation?.... "

It is expensive to have this done.... and for a 145K purchase any benefit will exceed the cost of the plan (you need engineers, architects, accountant, construction professionals, lawyers, etc. to do a proper plan)....

[cpadvisor]

So unless the taxpayer is able to afford fancy accountants, engineers, etc ... they're not allowed to take legitmate deductions? To me this would be just like allocating between land and buildings. Find an appropriate way to allocate some of the purchase price to the various items that have a shorter useful life...

From www.barneswendling.com/pdf/pjs_0308.pdf

"The value of the tax benefits have to be
weighed against the cost of the study.
Generally, buildings costing under
$500,000 will not produce enough accelerated
deductions to justify the expense and
effort of a study. For these expansions, any
tangible personal property that is clearly
identifiable should be separated from the
overall project cost and depreciated over
the shorter life."

[commentator]

I'll go with mwcpa's reply #9 on the cost segregation question and I base my opinion on the first line quoted by cpadvisor - "The value of the tax benefits have to be weighed against the cost of the study."

Everyone is allowed to take legitmate deductions. Everyone should still consider the cost of computing (and justifying) that deduction to the benefits of reduced taxes.

[mwcpa]

cpa.... the issue at hand is the cost of the study.... you cannot just arbitrarily allocate costs, proper cost segregations studies are required to determine what components are not part of the actual building.

From my friends at RIA.... please note the findings in the courts

"Taxpayers that want to claim rapid depreciation deductions for part of a building's cost on the ground that part of it is tangible personal property will need detailed, objective proof in the form of construction, engineering or architectural reports (collectively referred to as cost segregation studies). That is particularly true when a taxpayer seeks to treat part of the electrical system as tangible personal property based on the percentage of the electrical load allocable to a business as opposed to the building's operation or maintenance. Fast depreciation will be denied where a taxpayer can't prove what part of the electrical load is allocated to special machinery. Thus, a taxpayer couldn't treat 75% of the cost of a storage facility's electrical system as tangible personal property, because it couldn't prove that 75% of the system was essentially dedicated to custom machinery in a warehouse. The taxpayer introduced no evidence relating to the proportion of electricity used by the special machinery. (L.L. Bean Inc v. Com., (1998, CA1) 81 AFTR 2d 98-2114 , 145 F3d 53 , 98-1 USTC ¶ 50454, affg on this issue (1997) TC Memo 1997-175 , RIA TC Memo ¶ 97175 , 73 CCH TCM 2560 )

An allocation based on a study conducted by another company in the same business also was rejected. (Boddie-Noell Enterprises v. U.S., (1996, Ct Fed Cl) 78 AFTR 2d 96-7134 , 36 Fed Cl 722 , 96-2 USTC ¶ 50627, affd without op (1997, CA Fed Cir) 80 AFTR 2d 97-8288 , 132 F3d 54 (unpublished))

In Chief Counsel Advice issued after the Hospital Corp. of America decision (Chief Counsel Advice 199921045), IRS told examiners that an accurate cost segregation study can't be based on “non-contemporaneous records, reconstructed data, or taxpayer's estimates or assumptions that have no supporting records.”"

While one can avail themselves of the analysis, one needs to bear in mind the cost.... remember the benefit of the study is the acceleration of the deduction and the related time value of money.... if a passive rental operation is going to generate losses then the cost of the study may provide no real value.... one needs to review the possible benefits and the costs before starting one of these projects....by all means, if the benefits exceed the costs, go for it....I have been involved with a couple of them and they were "fun" summer projects (and in one case my client have hundreds of thousands in savings, time value of money savings, which gave him some extra post tax cash to do improvements, which were also included in the study....)

[ezorn33]

So, I'm pretty sure I screwed this up in past years and would have done so again this year without this post. I bought a condo in May 2007 and lived in it until November 2010. For much of that time, I rented out the second bedroom. When reporting that extra income on my taxes (using H&R Block's software), it never occurred to me that any portion of my purchase price was for land, so the basis I've been using for depreciation thus far has been the entire purchase price.

Of course, now that I think about it, that was a pretty dumb oversight, and one I'd like to correct, especially now that I have moved out of the condo and turned it into 100% rental property.

How do I go about correcting past returns? I assume I can't just use the correct number this year and in the future and hope no one notices...

[cpadvisor]

From Checkpoint RIA PPC guidance:

"303.22 Form of CostSegregation Study The IRS CostSegregation Audit Techniques Guide makes interesting reading for any practitioner with clients buying or building real property. (In fact, for practitioners who are unfamiliar with the construction process, the Guide provides a good general discussion of the construction process from concept through completion.) Neither the IRS nor any group or association has established any requirements or standards for the preparation of costsegregation studies. The Guide provides that substantiation using actual costs is generally preferable to the use of estimates. However, in situations where estimation is the only option, the methodology and the source of any cost data should be clearly documented. In addition, estimated costs should be reconciled back to actual costs or purchase price. The Guide provides a discussion of detailed steps auditors use to evaluate the validity of a costsegregation study. The Guide looks at six types of studies and evaluates them as follows:

a. Detailed Engineering Approach from Actual Cost Records. The detailed cost approach uses costs from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation. The Guide indicates this type of study produces the most accurate cost allocations. Unfortunately, this is also the most expensive type of study and can only be applied to new construction, where detailed cost records are available.


b. Detailed Engineering Cost Estimate Report. The detailed estimate approach is similar to the detailed cost approach. The difference is that the detailed estimate approach estimates costs, rather than using actual costs. This approach is used when cost records are not available or for an acquisition when the purchase price must be allocated. The Guide indicates that if detailed cost estimates are prepared by qualified individuals, and the estimates are reconciled to actual costs, reasonably accurate cost allocations are possible.


c. Survey or Letter Approach. The survey or letter approach is an alternative method for estimating costs. In this approach, contractors and subcontractors are contacted via a survey or letter to provide information on the cost of specific assets that they installed on a particular project. These costs are then used in one of the engineering approaches or in the residual estimation approach (discussed in item d). The Guide indicates that in situations where the contractor provides actual cost data, the allocations may be reasonably reliable. However, when contractor data is obtained from other sites or projects, the data may not be comparable or reliable.


d. Residual Estimation Approach. The residual estimation approach is an abbreviated method where only short-lived (5–7 years) asset costs are determined. Short-lived asset costs are added together and then subtracted from the total project cost. The residual cost is then simply assigned to the building. The Guide warns that this method is less accurate than the previously discussed methods and that it does not reconcile total project costs. In general, residual costs are not estimated or checked for reasonableness. The Guide warns auditors that the different estimation techniques for short-lived assets can produce a skewed result in favor of IRC Sec. 1245 property and recommends determining a proper and reasonable residual cost, and then adding that residual cost back to the cost of short-lived asset costs to determine if total project cost is reasonable.


e. Sampling or Modeling Approach. The sampling or modeling approach uses a created model (or template) to analyze multiple facilities that are nearly identical in construction, appearance, and use (traditionally, fast food chains and retail outlets). The Guide warns that the sampling method used may not be statistically valid, and that a population of less than 50 could limit the accuracy of a sampling technique unless an appropriate sampling error is considered. Additionally differences in building codes, geographic location, and material and labor costs may make it difficult to determine an appropriate model.


f. Rule of Thumb Approach. The rule of thumb approach uses little or no documentation and is based on a preparer’s experience in a particular industry. For example, a preparer may estimate IRC Sec. 1245 property as a fixed percentage of project cost by relying on industry averages. The Guide warns that examiners should view this type of approach with caution since it usually lacks sufficient documentation to support its allocation of project costs."

[Deleted]

"So, I'm pretty sure I screwed this up in past years and would have done so again this year without this post."

"How do I go about correcting past returns? I assume I can't just use the correct number this year and in the future and hope no one notices... "

Well unless you're in a really expensive area the ratio of land to improvement in a condo is pretty low; often at 20% to 30%. How much were you claiming each year for depreciation?

While I'm not an advocate of cheating, unless you're talking about a lot of money I'm not sure it's worth the hassle of going back and filing amended returns for 2007-2009. Make sure 2010 is correct for when you placed the entire unit into service and moving forward. Frankly so many people don't even bother reporting roommate income iin the first place you're already good in my book!

[Deleted]

"As far as the closing costs are concerned, they are not deductible. Such costs are added to your basis in the property, and are depreciated."

Some of them. Costs associated with the loan, like points, title, et cetera are amortized over the term of the loan. If you refi or pay off the loan you can deduct those (old) loan costs the year that loan is paid off. So keep that closing sheet handy!

[Deleted]

"Repairs etc are all deductible"

Not necessarily. Some "repairs" are treated as capital improvements and need to be broken out and depreciated separately. I have some really odd depreciating schedules going on with some of my properties. My Bay Area accountant has the new fireplace mantle on a separate schedule as well as carpeting. Both were installed just before we converted the house to a rental. We purchased the house in 1996 and converted it in 2003 when we moved to AZ.

My AZ house has a separate schedule for the kitchen (remodeled in 2005) and 2 bathrooms (done just before we moved out in Aug 2009). But the weirdest is the schedule for the $1,600 shade I installed just before we left. It's a bit of a gray area so one accountant had advised me we needed to capitalized every repair over $2,000 and the ones the company provides while we're living overseas capitalize every thing over $1,000.

[commentator]

Here's a general response. Don't buy a house to use as a rental until AFTER you have consulted with a licensed tax pro who is knowledgable of rental activites. In fact, don't start any income generating activity until you have consulted with an informed tax pro who has no vested interest in what you decide.

[Deleted]

"Don't buy a house to use as a rental until AFTER you have consulted with a licensed tax pro who is knowledgeable of rental activities. In fact, don't start any income generating activity until you have consulted with an informed tax pro who has no vested interest in what you decide."

Ha, ha you take all the fun out of the game, LOL!

Seriously, I think the take away is that you don't invest in anything solely for tax reasons. It's too easy for laws to change and to get stuck trying to unload an investment that doesn't work for you and possibly in a bottom market if everyone else is trying to unload the same investment.

Obviously we work closely with our CPA but I recognize that the rules can change. A major disappointment to me was when the tax laws changed two years ago and now one must prorate capital gains for property placed in rental service starting in 2009. So my plan to shelter all the capital gains by moving into our houses for 2 years and harvest capital gain won't be as lucrative as originally planned. Oh well, it's still a pretty good deal.

[mwcpa]

"It looks like a great way to avoid paying capital gains, but also benefit from depreciation"

Rachet,

1. 1031 is an effective way for some to defer, not avoid, capital gains...
2. when one "replaces" a property in a 1031 exchange the depreciation does not restart, you have carry over basis... simple, simple example

you have a rental property called A that cost you 100K (20K was land and 80K was building)... it is fully depreciated and worth 1 million and has NO mortgage or any debt associated with it.... you exchange it for replacement rental property called B in a qualified 1031 exchange that is worth 1 million and no money is involved what so ever.... your basis for depreciation is the same in property B as it was for property A.

for those interested in 1031 exchanges, be careful. There are many very specific rules that need to be followed and if they are not then forget any benefits you may think you are getting.

[Deleted]

We did one 1031 in 2005 from a commercial property into a SFH. As MWCPA says, you must follow the rules very carefully.

"As long as your ultimate goal is not to eventually sell the home and get a large infusion of cash from it in your retirement that is"

That is our plan. We currently have 5 rentals. That's enough!