You just bought an investment property. It needs some cosmetic work, but nothing major. Whether it’s your first or tenth property, you’re excited. You’re eager to get started on the rehab so you can rent it out and begin earning some cash flow.
You start the rehab right away. Two months and $15,000 later, it’s all done. It looks perfect, just like you envisioned. Now it’s time to rent it out!
You post an ad on Craigslist, stick a “FOR RENT” sign in the front lawn, list it on the MLS, or whatever else you may do to find a tenant.
Who sees something wrong with that chain of events?
If the above scenario resonates with you, continue reading at your own risk – it may make you a little queasy to learn how much one tiny misstep may have cost you.
Placing Your Property “In Service”
This entire topic revolves around one date – the date your property is placed in service. Why is it so important? Because on this date:
- Your property is considered to be in use
- Depreciation begins
- You can begin deducting operating expenses
More on this in a minute.
First, let’s define exactly what in service means. According to the IRS, your property is placed in service when it is both ready and available for rent.
In service = ready and available
I know it seems like I’m giving you ice in the winter but stick with me. Let’s drill down further:
Ready = livable
There is no hard and fast rule or guideline to determine what is deemed to be ready, or livable. If you’re doing a full gut rehab or major repairs, it’s pretty obvious the place is not livable and, therefore, not ready. Generally, minor rehab work to a property that’s already inhabitable is okay.
Available = advertised for rent
This one is much more clear. Your property is considered available for rent the day you put a sign on your front lawn, post it to Craigslist, list it on the MLS, etc.
Note – If you inherit tenants (buy an investment property that’s already occupied), your property is placed in service immediately on the date of closing. This holds true even if you get rid of those tenants and replace them with your own.
Now that you know what the in-service date is, can you see where the mistake was made in the earlier example?
Expensing vs. Capitalizing
As mentioned earlier, you are able to begin deducting operating expenses once your property is placed in service, meaning you can deduct them in full against your rental income.
But what about all the expenses you incurred before you placed your property in service?
They are either added to the basis of your property and depreciated over its useful life (27.5 years for residential real property) or capitalized as start-up costs and amortized over 180 months.
I think we can all agree that expensing items in full in the year they were paid as opposed to depreciating them over a set amount of years is much better.
So, how can we make sure that happens?
Advertise, Advertise, Advertise!
I can’t stress enough the importance of advertising your property for rent the instant it’s ready/livable. That will determine your “in service” date and will allow you to begin expensing items in full instead of capitalizing and depreciating/amortizing them.
For example, if you paid a handyman $275 to do a small job before your property was placed in service, it would be added to the basis of your property and depreciated over 27.5 years; this would generate a whopping $10 deduction per year spread out over the next 27.5 years.
If you paid that same handyman the same $275 for the same job after your property was placed in service, you would be able to deduct the $275 in full that year.
See the difference?
Tax Impact
Let’s continue this concept with the $15,000 from the example in the intro of this article.
Assuming you spent that $15,000 on various repairs and improvements before you had advertised your property for rent, you’d have to capitalize it by adding it to your property’s basis and depreciating it over 27.5 years. This would give you a deduction of about $545 per year over the next 27.5 years.
If you’re in the 24% bracket, that translates into approximately $131 of tax savings ($545 x 24%) per year as a result of your rehab.
If you spent that $15,000 after you had advertised your property for rent, you would be able to deduct it in full, assuming each expense falls under the de minimis safe harbor amount of $2,500. A repair or improvement over $2,500 generally must be capitalized but can still be deducted in full thanks to the current 100% bonus depreciation.
If you’re in the 24% bracket, that means $3,600 of tax savings ($15,000 x 24%) in the current year (assuming you have the rental income to absorb the full $15,000 of expenses)!
If your rental income is less than your total expenses (including the $15,000), don’t worry, the losses are not lost; they carry over and can be used to offset future rental (or other passive) income.
Added Bonus
If you’re familiar with depreciation and depreciation recapture, you know how great the former and how awful the latter can be.
If you wait to advertise your property for rent until after your rehab is completed, all those costs would be capitalized, depreciated, and then subject to depreciation recapture upon sale.
Instead, if they were expensed (meaning you advertised for rent before rehab), depreciation recapture would not come into play.
Sounds like a win-win to me.
My Recommendation
Place your property in service as soon as possible by advertising it for rent the instant it’s considered “ready”, or livable.
You will then get to reap the benefits of expensing items in full as opposed to capitalizing and depreciating/amortizing them over what will feel like forever.
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Aiola CPA, PLLC is a 100% virtual CPA firm, specializing in tax planning and preparation for real estate investors. See more at www.aiolacpa.com
