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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.
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.
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.
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.
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.
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.