When projecting taxable income from your new rental property be mindful of start-up expenses
Expenses incurred prior to the commencement of a business are not currently deductible. In the instance of rental real estate, costs incurred before a property is ready to be rented are considered start-up expenses.
What are start-up expenses?
Start-up expenses generally fall into three categories:
- Investigatory costs – amounts paid or incurred in connection with investigating the creation or acquisition of a trade or business.
- Formation/organizational costs – amounts paid or incurred in creating an active trade or business.
- Pre-opening expenses – amounts paid or incurred in connection with “any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.”
How are start-up expenses treated for tax purposes?
Costs that have been identified as start-up expenses are treated differently for income tax purposes. The expenditures cannot be deducted automatically in a single year. Since these costs are deemed to provide a benefit over multiple years, they are treated as capital expenditures and must be deducted in equal amounts over 15 years. There is a special provision that allows taxpayers to deduct up to $5,000 in start-up expenses in the first year of active business, with the balance amortized over 15 years.
What about expenses to obtain a mortgage?
Certain settlement costs incurred in connection with obtaining a mortgage are required to be amortized over the life of the mortgage. Expenses such as mortgage commissions, loan processing fees, and recording fees are capitalized and amortized.
Points are charges paid by a borrower to obtain a loan or mortgage. Sometimes these charges are referred to as loan origination fees or premium charges. Points are essentially prepaid interest, but cannot be deducted in full in the year of payment. Taxpayers must amortize points over the life of the loan for their rental property.
When is a property deemed ready for rent?
There is considerable confusion about when property is ready for rent and rental activity begins for income tax purposes. It is important to establish this point in time as subsequent expenditures are no longer treated as start-up expenses requiring capitalization.
The rental activity begins when the property is ready and available for rent, not when it has actually rented. In other words, expenses incurred by the landlord while the property is vacant are not start-up expenses. For example, assume a taxpayer landlord has a vacant property that is being advertised for rental and has received a certificate of occupancy, but the landlord has not been able to find a tenant for three months. The costs incurred during that time period are not considered start-up because the property is ready and available for rent.
If a taxpayer does incur start-up expenses, they should be separated and capitalized in accordance with the Internal Revenue Code. Proper tax planning includes minimizing start-up expenses to the extent possible and/or keeping them below the $5,000 threshold.