Investors: How to Treat Real Estate Start Up Costs

I had an interesting conversation the other day with a real estate investor. He has been in the game for a couple of year and has a small portfolio. His tax and accounting advice had come primarily from Google searches and other investors. During our conversation, it became obvious that he didn’t know how to treat his real estate start up costs. His methodology, which I’ll discuss shortly, may make you cringe. 

This gentleman is not alone. Many amatuer investors make mistakes when it comes to treating expenses properly and tax reporting. That’s half the reason I opened my practice as I saw this huge need for help. Seriously, you’d be surprised if you heard the crazy strategies some of my potential clients suggest during our initial consult.

I’m going to highlight the key mistakes this investor was making in treating his real estate start up costs. I’ve also realized I’m going to need to write a completely different article to take a deeper dive into some of these topics. Read on!

Mistake #1 – Not Understanding What is Included in Real Estate Start Up Costs

Not all costs are going to be considered start up costs that you can elect to deduct or amortize. So it’s important to understand which costs can be considered start up costs and which costs must be capitalized and added to the basis of your future rental.

The investor I was speaking with thought that he could deduct everything under the moon as a start up expense. Of course, this is not the case. You can deduct the majority of start up costs, but only if they are in line with the rules. This is why tax planning can add immense value.

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Real estate start up costs must meet two criteria. The first is that they will be those that you could generally deduct if you already had the rental in service. The IRS specifically calls these costs “those paid or incurred to operate and existing active trade or business.” The second is that these costs are incurred prior to placing the property into service.

A rental property is placed in service when it is advertised for rent. If on the day of closing you already have tenants in the property, your rental is placed into service on that day. Otherwise, it’s placed into service the day you stick a sign in the front yard or place that Craigslist ad.

Related: Hiring a CPA is Key to Your Success

Examples of costs that will qualify as real estate start up costs include amounts paid for the following:

  • Analysis or survey of potential markets;
  • Advertisements for tenants or mailers to find distressed sellers;
  • Fees paid to receive legal, accounting, and other professional services; and
  • Travel and exploration costs.

To all of my tax savvy readers out there, fees paid to receive professional services in regards to forming entities are considered “organizational costs” but are essentially treated the same way.

Of course, there are also costs that don’t qualify, some of which may surprise you. These include deductible interest, taxes, and research or experimental costs. If you incur these costs prior to actually purchasing your rental, you will need to look at amortizing the costs. We’ll discuss that later.

Mistake #2 – Assuming the Purchase Price is Deductible

Shocking, I know. Our John Doe investor was deducting the purchase price on his tax returns. Without professional help, it’s only a matter of time before he unfortunately has to deal with a full blown audit.

The cost to purchase a property will not be considered as one of the qualifying real estate start up costs. When you purchase a rental property, you won’t be granted a big write off for the purchase price. This is because purchasing a rental property is seen as moving money from pocket A to pocket B.

Purchasing a rental property is seen as moving money from pocket A to pocket B.

This of course makes perfect sense. You aren’t granted a write-off when you purchase shares of your favorite stock, and you shouldn’t be. You can think of the new property as a personal “bank” and the money you invested as sitting in that bank’s savings account.

So when you do go ahead and write off the purchase price of a rental property, you’re jumping head first into hot water. Lava water actually. If that’s a thing.

Can you imagine the massive write-offs and tax savings you’d have? While that would be nice, it isn’t the way the tax law works. On top of that, when you sold the property at a later date, you’d have to recognize the entire sale as income. Yikes. Speaking hypothetically here of course as we now know this situation should never, ever arise.

Mistake #3 – Deducting Travel and Exploration Expenses

Who likes to travel? Everyone! And if you’ve been to any of those whacky seminars, they tell you that you can deduct all the travel costs in the world as long as you are looking for a rental. John Doe investor bought in and thought he was doing the right thing.

But this isn’t the case. When you incur travel expenses outside of your tax home, and you don’t have a rental property in the general geographic location of where you are travelling to, the travel costs are non-deductible. They won’t qualify as real estate start up costs. They won’t qualify as currently deductible expenses. And they won’t even be added to the basis of your future rental unless said rental is within the same geographic location that you incurred the travel costs in.

Your “tax home” is the general area in which you live/work.

When you travel to explore new rental markets or tour rental properties, you will want to keep solid documentation of that travel. At some point in the future, if you end up purchasing a rental in the same area in which you travelled to and incurred those expenses, you’ll be able to deduct or capitalize and depreciate/amortize the travel costs.

Related: The Ultimate Guide to IRS Schedule E for Real Estate Investors

Here’s a nifty graphic I put together in an attempt to further explain this concept. I’m an accountant by trade so don’t laugh at my inept artistic abilities.

Deducting Travel Expenses

As you can see, John Doe travelled to Florida for the beach. While he was there, he toured a few rentals. He also travelled to Washington, D.C. and New York city and toured potential rental properties in those cities as well. He bought a property in Washington, D.C. The travel costs he incurred on his Washington, D.C. trip can either be deducted as an expense or capitalized and depreciated/amortized.

You are probably wondering what happens to the costs of travelling to Florida and New York City. Well, those costs simply sit on your books. You don’t do anything with them until you purchase a rental property in the areas you travelled to in Florida or New York City. So plan your vacations wisely!

Mistake #4 – Failing to Amortizing Real Estate Start Up Costs Over $5,000

Now we’re down to the final mistake this investor made. On top of everything else we have discovered thus far in this article, our investor was expensing every expense associated with starting up his business. If anyone has spent more than an hour researching tax laws, they know that the IRS simply won’t make it that easy on us.

Real estate start up costs that exceed $5,000 must be amortized. “Amortize” is a fancy word us accountants use that really just means “depreciate” or recovery of your costs. The major difference is that you amortize intangible expenses and depreciation tangible expenses.

Prior to buying a rental, all of the qualifying real estate start up costs you incur will be added to the basis of your new rental. There is one minor exception to this rule: you can deduct up to $5,000 of your real estate start up costs in the year that your rental is placed into service.

The excess amount of real estate start up costs over $5,000 will be amortized over a 180 month period. So each month, you will get to recover some of your start up costs for 180 months.

As an example, let’s say you incur qualifying real estate start up costs of $6,000. You can elect to deduct $5,000 in the year your rental is placed into service. The remaining $1,000 is spread out over a 180 month period and slowly recovered. You don’t have to make the election to deduct $5,000 and can instead amortize all of your start up costs.

Now for some fancy talk. To make the $5,000 deduction election, you must attach a statement required by Regulations sections 1.195-1(b), 1.248-1(c), and 1.709-1(c). The statement will have an itemized listing of the start up costs you are electing to currently deduct. Another good reason to keep excellent records of your expenses (especially related to travel).

Wrapping This All Up

As you can see, deducting real estate start up costs is a real thing. It’s important to keep an accurate record of the costs you are incurring and to also make sure you are treating these start up costs correctly. If you avoid the four mistakes listed in this article, you’ll be well on your way to starting, or expanding, your real estate empire in a tax efficient manner.

About Brandon Hall

As founder and CEO of The Real Estate CPA, Brandon is focused on growing a CPA firm that provides real estate clients with an awesome experience. Brandon was named 40 under 40 by CPA Practice Advisor in 2018. Brandon leverages his personal real estate investing and his Big 4 Accounting experience to offer unique insights to his clients. Brandon enjoys CrossFit and Kiteboarding when he's not crunching numbers.

11 Comments

  1. Daniel Jordan on May 22, 2017 at 5:28 pm

    I am confused. I was reading that the $5,000 startup expenses are only deductible in an active trade . However, section 195 is inapplicable to rental property because renting is not considered an active trade or business, but rather a passive activity. Can you please clarify?

    • Brandon Hall on May 24, 2017 at 12:13 pm

      Sure thing! Legislative history shows us that even a single rental property, pending the right facts and circumstances, can rise to the level of an active trade or business(1). In 1983, the IRS released TAM 8350008 which held that their position is that a property held solely for rent does not rise to an active trade or business, however subsequent PLRs have demonstrated that the IRS has backed down from their 1983 position.

      If an investor comes to us with a handful of rental properties, we’re likely advising them that their rental portfolio is a passive activity. If an investor comes to us with a short-term rental (AirBnB), we’re likely taking the opposite position.

      (1) See, e.g., Hazard v. Commissioner, 7 T.C. 372 (1946), acq., 1958-2 C.B. 7; Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953); Schwarcz v. Commissioner, 24 T.C. 733 (1955), acq., 1946-2 C.B. 3; Post v. Commissioner, 26 T.C. 1055 (1956), acq., 1956-1 C.B. 5; Elek v. Commissioner, 30 T.C. 731 (1958), acq., 1958-2 C.B. 5; Fegan v. Commissioner, 71 T.C. 791 (1979), and aff’d, No. 79-1890 (10th Cir. 1981).

  2. Judi Nickerson on July 2, 2017 at 7:16 pm

    Great article! As to the travel to Florida for our hypothetical, if our Investor had a business meeting/lunch about the potential expansion of business in the area, up to and including the rentals or the Florida market, then these are deductible business expenses, correct?

  3. Judi Nickerson on July 2, 2017 at 7:19 pm

    Are educational expenses (i.e. tuition) as an Investor to support your startup deductible as intangible business expense?

    • Brandon Hall on July 7, 2017 at 1:09 pm

      Education expenses that are incurred pre-business opening are not deductible. Education expenses incurred after you have started business can potentially be deductible. Depends on the facts and circumstances.

  4. Douglas Reed on February 12, 2018 at 1:46 am

    Brandon,

    Thanks for your article, I am working through my MBA capstone and have learned a lot from your various posts. I have one question regarding startup costs. I read in an article in the Tax Advisor (Ellentuck, 2017) that startup costs can include “preopening repair and maintenance of capital assets used in the business” can be written off as startup costs. Does this include the repair and maintenance of a house flip? The article also states startup costs can be accrued for a current business that is expanding, Does the preparation and purchase of a new property during house flipping part of this startup cost?

    I am working on the financial plans for a business plan and just wanted to ensure I understood the finer points. Between your articles here and in BiggerPockets, and Elluntuck’s article, I now have a better understanding of what startup costs are for the financial section.

    Thanks,
    Doug Reed

    • Brandon Hall on February 12, 2018 at 11:18 pm

      Hi Doug – thanks for the kind words. I would image the author is referencing personal property assets instead of real property. Our interpretation is that landlords can take start-up costs that include pre-in-service repairs and maintenance but that flippers, developers, builders cannot.

  5. Patrick on April 18, 2018 at 5:54 pm

    Thank you Brandon for such a nice article. I read your articles on BiggerPockets and just found this website yesterday. Many of my tax related questions have already been answered.
    I don’t know if you thought about it, but I think you should write a real estate tax book. Parts of taxes that new investors like myself are overlooking revolve around the activities/cost incurred prior to closing on a deal or prior to having the property on service. Having a book that walk new investors through the different phases would be wonderful. In the mean term, could you suggest real estate tax books?
    Thank you

    • Brandon Hall on May 7, 2018 at 1:03 am

      Thanks Patrick! One of the best RE tax books is the NOLO Guide for Landlords. Check it out.

  6. Derek on May 7, 2018 at 9:56 pm

    Thank you Brandon for the helpful advice. Can you claim the $5000 start up expense twice if I have a duplex? I haven’t rented it out before and I’ve owned it for 10 years. I’m currently remodeling the front and back.

  7. Caroline on June 19, 2018 at 3:49 pm

    Thanks for the informative article – so I have a scenario where I’ll be traveling to Memphis to see a property I’m under contract for (but not for rent yet since it’s under rehab). Is the travel expense (we’re talking < $1k) considered a start up cost? If so – does this need to be amortize or can it be deducted in the year of purchase?

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