By Jason Watson, CPA
Posted Saturday, March 21, 2026

We just beat the IRC Section 195 start-up expense rules to death in the previous section. As a quick refresher, these are the investigatory and pre-opening costs you incur before your business officially begins (education, market research, consulting fees), and you eventually get to deduct them. But there is a massive practical wrinkle we need to iron out.

Tax returns operate on a strict 12-month calendar, but real estate deals rarely respect December 31st. What happens when your spending doesn’t neatly match your closing dates? What happens to the cash you spend in one year if the rental property doesn’t officially launch until the next?

The tax treatment in a cross-year scenario depends entirely on when, or if, that rental activity actually begins.

The December Spend, April Close

Suppose you spend $5,000 as start-up expenses in December researching potential rental investments. You go under contract quickly but do not close and place the property in service until April of the following year. What happens on your earlier tax return? The tax year that you shot the money cannon on investigation and exploration?

Absolutely nothing. Because the active rental activity has not yet begun, those December expenses are held in suspense. You just park them and wait. There is no Schedule E to put them on yet, and Schedule C is out of the question, too. Once the property is placed in service in April (ready and available for rent, with related efforts to rent), you aggregate those prior-year costs with any new pre-opening costs and run them through the start-up expense meat grinder on your current-year tax return.

What Happens If Deal A Falls Apart But Deal B Closes?

A common misconception is that start-up costs must be tied to a specific property. They do not. IRC Section 195 applies to the process of starting a business, not the purchase of a particular asset. Not distinguishing start-up expenses and acquisition costs is a common mistake.

Suppose you spend money researching, inspecting, and evaluating Deal A. After negotiations, the transaction falls apart. A few months later, you purchase Deal B instead. Those earlier costs do not disappear. As long as the expenses were incurred while investigating the same underlying business activity which for you is owning and operating rental real estate they qualify as start-up costs once Deal B is placed in service. The costs attach to the business you are launching, not the specific property.

What If You Never Buy a Rental?

Sometimes the search simply fizzles out. The market changes, the numbers don’t work, or life gets in the way. If no rental activity ever begins, those investigatory expenses are generally non-deductible. Because you never actually entered into a profit-seeking activity, you cannot claim an abandonment loss. The expenses just disappear into the ether.

The December Furniture Trap (A Quick Warning)

Start-up expenses should not be confused with tangible property purchases, like furniture or appliances. But cross-year timing matters here, too. We dug deep into this in a previous section, so the following is just a truncated teaser.

Let’s say you spend December buying a $2,000 couch, a $1,500 dining table, six chairs at $350 each, and a whole slew of furnishings totaling $40,000. You finally place the house into service as a rental on January 1. Normally, you would use the de minimis safe harbor to immediately expense those items since they are individually under $2,500. Yay!

However, as we detail in our furnishings and supplies section on page 75, tangible assets are governed by placed-in-service rules, not start-up rules. Because the business wasn’t legally active in December when you bought the furniture, you lose the ability to use the safe harbor operating expense deduction. Instead, you are forced to capitalize that furniture, book it as an asset with a January 1 placed-in-service date, and take bonus depreciation or Section 179 expensing accordingly.

Sidebar: As the risk of repeating and since readers jump into our content at different places, we must tease this too. Bring up a December furniture purchase for a January rental launch at a tax conference, and you will start an immediate fight over whether the de minimis safe harbor legally survives the calendar flip. One side argues the deduction completely collapses into a capitalized asset because the business wasn’t active in December, while the other insists the expense simply waits in tax purgatory until opening day.

In our continued opinion, the key principle is simple: nothing happens for tax purposes until the rental activity actually exists. See our furnishings and supplies section.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

Ok, who wants some easy stuff? After all that start-up expense nonsense, we all do, right? All the kitchen wares, linens, and supplies such as paper towels, coffee pods, soap, etc., are immediately deductible provided they are $2,500 or less per item or invoice (see our discussion on rental property safe harbors section). Furnishings will likely qualify as well, unless you spring for an expensive sectional or a fancy dining table. We’d be wary of any hot tub that costs $2,500 or less. Bonus depreciation and Section 179 expensing are your backup options should some of your furnishings not be eligible for the de minimis safe harbor.

Two comments on booking furniture purchases as rental property assets. First, if these furnishings were purchased after the rental property was officially placed into service, they can be immediately expensed as operating expenses using the safe harbor. Therefore, no bonus depreciation or Section 179 expensing is necessary. We see many tax practitioners mess this up- they see $40,000 in total furnishings and instantly think “CapEx,” completely forgetting to apply the safe harbor item-by-item.

Second, why does this matter? While booking the asset and using bonus depreciation or Section 179 expensing arrives at the exact same tax deduction today, you now have a lingering asset on the books that must be resolved when you eventually sell the rental property. We agree that deducting your furnishings as an operating expense and later selling them technically causes the same disposition grief. However, having a formal asset permanently listed on your tax return’s depreciation schedule makes this recapture process a bit “front and center” with a giant IRS spotlight on it. Avoid the discussion and keep it off the books if you legally can.

Pre-Opening Furniture Trap

Here is where timing will make or break your accounting strategy. Are pre-opening furniture purchases considered IRC Section 195 start-up costs? Absolutely not. Tangible assets are never start-up costs.

To understand the trap or pitfall or otherwise bad thing, you must look under the hood at how the tax code connects the dots. The de minimis safe harbor is a nice gift from the IRS, found in Treasury Regulation Section 1.263(a)-1(f). It acts as a statutory bridge: it takes a tangible asset that you would normally be forced to capitalize and depreciate under IRC Section 263, and magically transports it over to IRC Section 162 to be immediately deducted as a routine operating expense.

Hang in there… because here is the catch. And a fight. But the catch first.

Once the safe harbor pushes that expenditure into IRC Section 162 territory, you must play by Section 162 rules. Here is the exact text straight from IRC Section 162(a)–

(a) In general
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,

If you buy $40,000 worth of furniture in December, but the rental property does not officially become ready and available for rent (placed in service) until January 1, your business does not technically exist in December. You are not carrying on any trade or business at the time the expense is paid.

Therefore, you fail the IRC Section 162 test, the de minimis safe harbor says “sorry, Charlie,” and you are thrown right back into the capitalization rules of IRC Section 263.

Sidebar: Some might try to argue that these furniture purchases were made “in anticipation of a business.” Nice try, but those exact words belong to IRC Section 195, which speaks exclusively to start-up expenses. And as you already know, start-up expenses cannot be tangible property. You cannot use Section 195 logic to save a Section 162 deduction.

In this scenario, you are forced to book that $40,000 as a capitalized asset on your depreciation schedule. You cannot use the safe harbor retroactively once the calendar flips and the business opens. Instead, you must rely on bonus depreciation or Section 179 to deduct the expenditures once the rental is finally placed in service in January.

The critical timing rule for tangible property is not the purchase date- it is the placed-in-service date. The tax treatment follows the timeline of when the asset begins performing its intended income-producing function, not when the money left your checking account.

Different phases. Different handling. A visual reference-

Phase	Handling
Exploratory, Investigation	Start-Up Expenses
Property Identified	Acquisition Costs
Pre-Opening Furnishings	Capital Expenditures
Pre-Opening Expenses	Start-Up Expenses (again)
Ready and Available	Operating Expenses

Ok, having said all this, we must present an alternative approach.

CPA Bar Fight: Section 162 Versus Section 263

Put two tax professionals in a room to discuss this December furniture purchase, and you will get an argument. Why?

The safe harbor regulations explicitly state you must claim the deduction in the taxable year the amount is paid (December/Year 1). But to take a Section 162 deduction, you must be actively carrying on a trade or business as we’ve stated previously. Because the rental isn’t placed in service until January, the business doesn’t exist in Year 1. We all agree. Good. Now the fight.

Opinion A (The Capitalization Purist): Because you fail the active business test in Year 1, the safe harbor bridge collapses. You are thrown back into the capitalization rules. You must book the $40,000 as an asset, carry it into Year 2, and rely on bonus depreciation or Section 179 to deduct it once the property goes live in January.

Opinion B (The Capital Recovery Pragmatist): Other practitioners argue that the expense simply sits in tax purgatory until the property is placed in service in January. At that exact moment, the safe harbor wakes up, the business is now active, and you can expense it directly under de minimis.

Which opinion is right? Frankly, they both get you to the exact same finish line: a massive tax deduction in Year 2.

However, WCG CPAs & Advisors believe Opinion A is the safer, more strictly compliant mechanical route. When crossing calendar years, attempting to carry a safe harbor election which is designed for current-year cash outlays into a future tax year can get messy on the tax return. By capitalizing the furniture and utilizing Section 179 or bonus depreciation in Year 2, you perfectly align the tax deduction with the moment the asset begins performing its intended income-producing function, with zero risk of the IRS challenging your timeline.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

There are four types of expenses that you might have outside of the rental property purchase itself-

• Start-Up Costs such as Investigatory, Organizational (LLC formation, legal and professional fees) and Pre-opening Expenses. These are expenses incurred while preparing to enter the rental business, generally before the property is placed into service. They often occur before a target property is identified, but may also occur after identification provided they do not facilitate the acquisition itself.

• Real Estate Acquisition Costs.

• Lost Expenses (no sneak peek).

• Furnishings and Supplies (business-related expenses).

We’ll skip real estate acquisition costs since we have an entire section dedicated to that but dive into the other three (especially rental property start-up costs).

Start-Up Costs (Investigatory, Organizational and Pre-opening Expenses)

You can immediately deduct up to $5,000 of the following expenses (we listed the most popular)-

• Professional fees paid to lawyers, accountants, consultants, etc. to assist with getting the entity formed, drafting a sample lease, etc. Similar fees in connection with the purchase, however, are acquisition costs and are added to the basis of the rental property.

• Business licenses, permits, and other fees. These are not for the rental property itself, but rather general business licenses and permits.

• General real estate research (think AirDNA subscription) and best business practices, including educational seminars or conferences.

If you have more than $5,000 but less than $50,000 in these expenses, the difference is amortized and deducted over 15 years.

Let’s back up a bit since there is a fine line between start-up costs and acquisition costs. IRC Section 195(c)(1) defines “start-up expenditure,” in part,

as any amount (A) paid or incurred in connection with investigating the creation or acquisition of an active trade or business, and (B) which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred.

However, once you identify the target business, and in the context of this book, the target rental property, associated expenses are typically no longer start-up (investigatory) but rather capital in nature (acquisition costs). In other words, once expenses begin facilitating the acquisition of a specific property, they become acquisition costs and must be capitalized. Here is a nice summary from IRS Revenue Ruling 99-23 (yeah, way back when but still relevant)-

Expenditures incurred in the course of a general search for, or investigation of, an active trade or business in order to determine whether to enter a new business and which new business to enter (other than costs incurred to acquire capital assets that are used in the search or investigation) qualify as investigatory costs that are eligible for amortization as start-up expenditures under § 195. However, expenditures incurred in the attempt to acquire a specific business do not qualify as start-up expenditures because they are acquisition costs under § 263. The nature of the cost must be analyzed based on all the facts and circumstances of the transaction to determine whether it is an investigatory cost incurred to facilitate whether and which decisions, or an acquisition cost incurred to facilitate consummation of an acquisition.

Please do not confuse “acquisition costs” with “pre-opening expenses.” Pre-opening expenses occur after the decision to enter the rental business but before the activity actually begins (before the property is placed in service). These costs include expenses related to advertising, acquiring tenants or guests (Airbnb or VRBO initial setup costs), professional services, setting up books and records such as QuickBooks Online, Xero, REIHub, etc.

As the tax code puts it, these pre-opening activities are engaged in “in anticipation of such activity becoming an active trade or business.” Because you are doing these things specifically to get the doors open and launch the operation, they are perfectly valid IRC Section 195 start-up costs.

Possible Lost Expenses

Speaking of expenses between the closing date and the available-for-rent date (in-service date), what about mortgage interest, property taxes, insurance, and utilities while you are getting the rental ready?

Why aren’t these just lumped in with your pre-opening start-up costs? Because the IRS draws a hard line between creating a business and carrying an asset.

IRC Section 195 is designed for expenses that build the business framework. The tax code explicitly excludes interest and taxes from being treated as start-up costs. Utilities and insurance fall into a similar bucket since they are carrying costs that merely maintain the physical property, rather than activities executed in anticipation of launching the business.

Here is the abbreviated language from IRC Section 195–

1) Start-up expenditure The term “start-up expenditure” means any amount—
(A) paid or incurred in connection with—
(i) investigating the creation or acquisition of an active trade or business, or (ii) creating an active trade or business,

Blah blah blah

The term shall not include any amount with respect to which a deduction is allowable under section 163(a), 164, or 174.

Section 163(a) is the code section for deducting interest. Section 164 is the code section for deducting taxes such as property taxes. Because the rental activity has not yet begun, those deductions may not yet be allowed under IRC Sections 163 or 164 either. Wow, more bad news.

That sums up the spirit of IRC Section 195 and how it feels about carrying costs (we talk about this more in a bit).

In line which with we just learned from IRS Revenue Ruling 99-23 and IRC Section 195, these expenses are not considered start-up costs and can pose a real problem for real estate investors. You could possibly deduct the mortgage interest as a second home, but further discussion is required. You might be able to deduct the property taxes subject to the current $10,000 combined state and local tax limitations on Schedule A of your Form 1040 tax return.

What’s the answer? The answer is to get that rental property ready and available for rent and let the world know as soon as possible. Place it in-service like now.

You purchase a rental property on July 1, and it is generally ready to rent. Nothing says you must immediately pay a bunch of money for fancy pictures, staging and VRBO listings. The rental property is available with nothing more than your willingness and a yard sign. Then you can start shooting the money cannon.

Nothing says you must also align your rent fee with market conditions; for example, you buy a ski condo on September 1. No one is going to rent your condo until at least Thanksgiving, but it is available to rent, and as such you are no longer in the start-up phase.

Finally, nothing says you cannot have the rental property available for rent, and simultaneously be painting various bedrooms and walls waiting for your first tenant or guest.

Nothing has a lot to say, right?

This a) ready and available for occupancy and b) being held out for rental use (advertising and related efforts) standard makes sense- the asset is deployed for its intended purpose which is to produce income. Know the rules. Assert your facts accordingly. See our rental property in-service defined section for more information.

Sidebar: If you are constructing a rental property, then usually the construction loan interest and interim property taxes will be capitalized and added to the ultimate cost of construction. See our capitalizing construction mortgage interest section for expanded thoughts on this nugget.

Carrying Costs

As you can see you might be in no-man’s land or what some call “pre-rental status” or “pre-opening” where the rental property has never been rented before and is not yet ready for occupancy. Not all is lost during the time between closing and when the rental property is placed into service (ready and available for occupancy, and held out for rental use through advertising and related efforts). How?

If you elect under IRC Section 266 to capitalize certain carrying expenses (the election is made annually on a timely filed tax return) which is fancy accounting-speak for lumping expenses such as-

• Utilities (e.g., electricity, gas, water)
• Insurance
• Mortgage interest
• Property taxes
• Maintenance and security expenses

How does this immediately help you? It doesn’t. However, it allows you deduct these expenses in the future through depreciation or if you sell the rental property. See our capitalizing construction interest and carrying costs section for a bunch more information.

Recap of Getting the Rental Business Launched

A real estate investor could look at three discrete buckets of expenses or expenditures depending on different phases or timelines as you go from no rental to your first tenant or guest-

• You are considering purchasing your first rental property, but haven’t targeted one in particular. You incur some costs for a conference and for your pals at WCG CPAs & Advisors to assist in launching an LLC. These are start-up costs, and they may be immediately deducted as expenses if $5,000 or less, or amortized over 15 years (yuck).

• You target a rental property, and incur travel related expenses to inspect the property and close the deal. These are acquisition costs, and are added to the depreciable cost basis of the acquired property (and depreciated over 27.5 for residential or 39.0 years for commercial / short-term).
• You have several expenses buying kitchen wares, linens, supplies and furnishings. These are business related expenses to get your rental property activity underway. Typically, they will a) fall under the de minimis safe harbor and immediately deducted as expenses if $2,500 or less or b) immediately expensed with Section 179. We talk about both in a later section.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

This section isn’t as thrilling as others such as acquisition costs or 1031 like-kind exchanges, but at times it is an important consideration. Why would you want to convert your primary residence into a rental property (it is already a real estate investment of sorts, right?)? Here are some reasons-

You have an amazing mortgage interest rate, and don’t want to give it up necessarily. Keep in mind that mortgage interest can put a big dent into the internal rate of return (IRR) on a rental property. A 3% delta on a $400,000 loan is roughly a $1,000 monthly dent in cash flow. So, you need to go from $2,500 in rent to $3,500 just to break-even on the increased mortgage interest (sure, this assumes an early mortgage, and not one that you’ve had for seven years or more, but you get the idea).

You need to move quickly, but this year’s income is insanely high as compared to other years and your house’s gain exceeds the current $500,000 capital gains exclusion. This is a timing problem, right? Perhaps you can wait until next year to sell. You could also grab some cash with a home equity line of credit to tie things over. Cash-out refinance is more of a long-term commitment.

Your primary residence has been flat for a bit, and you suspect that there is a big boom coming to your geographic location. Therefore, you don’t want to sell before the prices start jumping but you also need to move for a job relocation. This allows you to cover your expenses with rental income while you await the wave of price increases on your way to an eventual sale with a nice rate of return.

Moreover, at times other investments in your risk profile are flat and you are concerned about where to park your money. Cash doesn’t seem like a good idea and buying another real estate investment puts you where you are today with a new data set of unknowns.

Perhaps your move is temporary. You are taking several years off to travel, visit the grandchildren, and drive your own children nuts. Why not? They drove you nuts, right? Parents forgive but never forget. However, your home is in a good location, has sentimental value and you plan to return later.

Rental properties can be tough to get into. Borrowing costs and underwriting guidelines can be more onerous when the property is not owner-occupied. Fortunately, the rental property investment landscape has favorably shifted towards traditional mortgage borrowing. However, and as many people in the military will tell you, moving from home to home, and converting prior properties into rentals can help accelerate your real estate acquisitions. Just a wake of homes converted into rentals- love it!

The OBBBA Bonus Depreciation Trap

If you are converting a home you purchased years ago into a rental property today, beware of a massive depreciation trap. Under the One Big Beautiful Bill Act (OBBBA), the permanent 100% bonus depreciation rate only applies to assets acquired and placed in service after January 19, 2025.

Because you originally acquired your primary residence prior to that line in the sand, the property fails the post-January 19, 2025 acquisition requirement under OBBBA. Even though used property can qualify for bonus depreciation under current law, the statute still requires that the taxpayer acquire the property after the legislative cutoff date. As a result, the property’s existing components that are later identified as IRC Section 1245 property from a cost segregation study are disqualified from the new 100% bonus depreciation rate. Bummer!

Instead, they are stuck with the much lower, original phase-down rates (such as 40% for property placed in service in 2025). However, any brand-new assets you purchase specifically for the rental after the conversion (like new appliances or fencing) will qualify for the full 100% because their acquisition date falls after the legislative cutoff.

The Section 121 Entity Shuffle

Inevitably, a clever investor will ask: “What if I sell my primary residence to my own S Corp or LLC? I can claim the IRC Section 121 exclusion (which allows married couples to exclude up to $500,000 of capital gains tax-free), give my entity a stepped-up basis, and claim 100% bonus depreciation as a new acquisition under OBBBA!”

It sounds brilliant, but the IRS built a brick wall for this exact maneuver. To qualify for bonus depreciation under IRC Section 168(k), the property must be acquired by “purchase.” IRC Section 179(d)(2) defines a purchase and explicitly excludes property acquired from a related party under IRC Section 267.

If you or your family own more than 50% of the buying entity, you are a related party, and the transaction fails the purchase definition. The entity gets zero bonus depreciation and is stuck with typical depreciation schedules. Yes, you will get the $500,000 tax-free exclusion on the sale, but No, you cannot reset the bonus depreciation clock. This gets tricky and carries risk.

Other Converting Your Home Into A Rental Considerations

A few things to keep in mind as you look to convert your home into a rental-

• According to Treasury Regulations 1.168(i)-4(b), your depreciable basis is either the adjusted basis on the date of conversion (what you paid for it) or the fair market value, whichever is lower. We’ll say it again, whichever is lower. Therefore, it does not matter that your property has increased in value.

• There is some tax arbitrage potential here, however. Let’s say your property is going to decrease in value for whatever reason. Losses on primary residences are not tax deductible. However, if you convert your home into a rental property, and it continues to decline in value, then at the point of future sale you might have a tax-deductible loss.

• If you plan to incur major renovation or remodeling costs, these expenditures should be made after the property has been placed into service (available for rent). This might allow for a higher depreciable basis of the rental property and increase your depreciation expense (partial asset disposition might come into play, which we discuss later). However, an argument could be made that your original purchase price plus the renovation becomes the combined adjusted basis. More discussion required,

Augusta Rule When Converting To Rental

This headline is a little misleading since the words Augusta rule and rental property are not typically mentioned in the same sentence. Why? IRC Section 280A(g) generally allows you to rent your primary residence to others for 14 days or less tax-free.

As such, could you rent your primary residence for 14 days, move out and then convert it to a rental property? Sure. Seems like a lot of work paired with a bunch of risk, but it is certainly possible. Keep in mind that if your facts are slightly flipped around where you move out of your primary residence and move into another home, and then attempt to claim the Augusta rule and grab 14 days of tax-free rental income, then the gig is up.

When does your primary residence no longer serve that purpose or fit that definition? It’s an abstract question, but the answer must prove your intent that during the 14 days of rental activity, you still viewed the property as your personal home.

We point this out only to illustrate that WCG CPAs & Advisors is turning over very rock when exploring all tax deductions and arbitrage when it comes to rental properties and real estate investments. Even the crazy and half-baked rocks. That doesn’t make any sense, does it? Half-baked rocks. Oh well.

The most important thing above all is to not visit your rental property. Some kidding aside, if this was your home where you raised children and manicured the lawn, it will be a gut punch on how others maintain your “business property.”

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here are some FAQs you might find helpful as a summary to our chapter on initial asset management, which is nerdy real estate CPA speak for getting your rental property online-

Can I deduct costs incurred before I find a rental property?
Yes, up to $5,000 of start-up costs are immediately deductible if incurred before identifying the property. Costs beyond that are amortized over 15 years, and there are other limitations.

How should I classify travel expenses when buying a rental?
Before targeting a property: start-up. After identifying: acquisition cost. After in-service: deductible operating expense. Booyeah!

What does “in-service” mean for a rental property?
“In-service” means the property is ready and available for its intended use—functional, safe, and compliant with local laws—and is being actively marketed for rent. It does not require a tenant to be in place.

Can a rental be considered in-service if it’s awaiting a short-term rental permit?
No. If your intended use is as a short-term rental and you’re waiting on permitting, the rental property is not yet in-service, even if otherwise functional.

What does “held out for rental use” mean?
It means you’ve made bona fide efforts to rent the property, such as listing it, engaging with potential tenants, or hiring a property manager—and you can document these actions.

What’s the “in-service” rule’s impact on taxes?
It determines when depreciation begins and when expenses are deductible. Without in-service status, tax benefits are delayed.

Are closing costs deductible?
Most are not. They’re capitalized as acquisition costs or amortized, depending on their nature.

How do I treat loan costs?
Loan costs are amortized over the term of the loan. If you refinance, the remaining balance may be deducted immediately subject to passive loss limitations.

Are prepaid insurance and taxes deductible upfront?
Often yes, under the 12-month rule, if the benefit doesn’t extend past the next tax year.

Why are acquisition costs depreciated and not deducted?
Since these costs contribute to the long-term use of the rental property, the IRS requires you to capitalize them into the property’s basis for future depreciation.

Do furnishings qualify for immediate deduction?
Yes, if under $2,500 per item via the de minimis safe harbor, or under Section 179 expensing if eligible.

What are the risks of classifying furnishings as assets?
You may trigger depreciation recapture or personal property tax. Consider using the safe harbor instead.

When does depreciation begin for a rental property?
Depreciation starts when the property is placed in service- not when it’s first rented. It must be rentable, advertised, and legally permitted to operate as a rental. Sound familiar?

What’s the depreciation schedule for a rental property?
Residential: 27.5 years. Commercial and STRs: 39.0 years. Loan costs are amortized over the loan’s life.

How do I determine land vs. building allocation?
The easiest way is to use the assessor’s data ratio or appraisal. Only the building portion is depreciable.

Can I deduct pre-rental mortgage interest and property taxes?
Only if the property is in service. Otherwise, they may not be deductible or only partially deductible. We’ll say it again at the risk of annoying you- get that rental in-service as quickly as possible.

Can I capitalize carrying costs?
Yes, under IRC 266, you can elect to capitalize certain interest, taxes, and utilities and other costs to “carry the asset.”

Can I take a rental property offline for repairs and still keep it in-service?
Yes. If you intend to rent it again and it’s still held for the production of income, the property remains in service during temporary downtime for renovations.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

Throughout this book, we use the term “in-service” and then parenthetically use the words “ready and available for occupancy, and held out for rental use through advertising and related efforts.” Having your rental property be considered in-service is huge for depreciation, operating expense deductions and material participation. Let’s break this down-

Ready and Available For Its Intended Use

Treasury Regulations 1.167(a)-11(e)(1)(i) reads in part-

(e) Accounting for eligible property
(1) Definition of first placed in service
(i) In general. The term “first placed in service” refers to the time the property is first placed in service by the taxpayer, not to the first time the property is placed in service. Property is first placed in service when first placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income, in a tax-exempt activity, or in a personal activity.

The term ready or readiness is not specifically defined by tax code or IRS publications, but it generally means the following-

• The rental property is in a condition that is suitable, functional and safe for occupancy. It is complete from a repairs or construction perspective, and has the operational capacity to generate income. Basic utilities such as electricity, water, sewer or septic, and heat are also required. Certain cabins and other outliers might not have electricity or heat beyond a fireplace, but you get the idea of suitable, functional and safe.
• The property is compliant with local ordinances. This one gets super annoying at times- you have a rental property, and you want to rent it as a short-term rental. However, you need a permit or zoning approval from the local authorities which is delayed several months. The rental property is otherwise ready, but unfortunately it is not ready for its intended use which is as a short-term rental.

The term available simply means that it is currently vacant, or will be vacant in the future. Additionally, there aren’t any unreasonable restrictions such as only people with green eyes can occupy the rental property. Its intended use is not necessarily to have a guest or tenant; that is the means. The ends, the intended use, is to produce income.

Being Held Out For Rental Use

This is also not defined very well, but over the years with several tax court cases and other accounting industry writings it has come to mean that a bona fide effort is made to genuinely offer the property for rent. This includes advertising and showing the property, and engaging with a rental property manager if applicable.

Next, and this is where taxpayers routinely get in trouble, your efforts must be documented. If you are tracking your time for material participation or real estate professional status (REPS), then this becomes more straightforward, but you are not out of the woods yet. The IRS and tax courts want more than just a time log that reads “advertised rental property.” They want to see how you advertised it, where, and the associated expenses. Do you have a mileage log showing you meeting a prospective tenant? Do you have names of those who inquired? Can you show emails and text messages to support your bona fide effort claim?

Finally, when considering the “being held out for rental use” standard, the tax courts often use the phrase the “property was held for the production of income.” Meredith v. Commissioner, 65 Tax Court 34 (1975) and Grant v. Commissioner, 84 Tax Court 809 (1985) are two common cases that use this phrase. In essence, and as scattered through this book, you must demonstrate that you are treating your rental property like a business- trying to find customers to generate income, among other business-like things.

Why do you care?

• Deduction of depreciation and operating expenses. See common rental property tax deductions section on page 205 for more information.
• Material participation time only counts when rental property is considered in-service. See what time counts for material participation section to groan about this rule. Yes, there are some short-term rental grouping concepts to help after acquisition and before in-service.

As a reminder, the in-service date is not your first rented day.

Taking The Rental Offline For Repairs or Renovations

Once a property is placed in service, it remains in service even if you take it offline for repairs or renovations provided that you intend to rent it again and consider the property held for producing income. Said differently, once placed in service, it remains in service unless it is no longer held for producing income (your intent, and defending what’s on your mind, becomes a big deal).

See our idle property versus vacant rental property section for a ton more information on this nuance.

The One-Day Rental Problem

Let’s look at a scenario that seems perfectly fine on paper. An investor buys a rental property, spends the year doing renovations, and scrambles to get it “placed in service” by December to knock a cost segregation study out and grab some bonus depreciation. They find a tenant for exactly one day, after which the property goes back offline for additional renovations (with or without suspicion, up to you) with zero activity the following handful of months.

It’s now April, and this same real estate investor wants to get the tax return filed. It looks like a brilliant tax hack, but defensibility is where things get genuinely interesting.

Real estate investors often obsess over checking boxes and logging material participation hours. But meeting mechanical time tests only matters if you actually have a valid rental activity. Before worrying about passive losses, the IRS requires an operation that functions as a legitimate, continuous business with a genuine motive to turn a net profit. As the Supreme Court made crystal clear in Commissioner v. Groetzinger, a true trade or business demands regular, continuous activity rather than sporadic, tax-driven maneuvers.

If that wasn’t enough to worry about, Congress codified the economic substance doctrine under IRC Section 7701(o). This rule dictates that a transaction is only respected if it meaningfully changes your financial position and has a substantial purpose other than just reducing your tax bill. If a real estate investor’s only actual motive for securing a one-day renter is to manufacture a tax loss, it fails this test entirely. Worse yet, when the IRS disallows a position based on economic substance, they slap on a strict liability penalty that is incredibly difficult to fight.

Many advisors mistakenly believe each tax year exists in a vacuum. While that snapshot approach works for calculating income, it fails completely when courts evaluate the legitimacy of an underlying business. Judges, who are humans and not robots, routinely look at historical and future patterns, analyzing what you did leading up to that one-day rental and what happened afterward.

When questioned, the typical defense is that the owner threw a listing on Craigslist and magically found someone to rent the property for one day. Relying entirely on a bare-bones ad for a single day, especially to a friend, even at market rates, feels less like a marketing strategy and more like a desperate checkbox. If the subsequent year shows no meaningful effort to rent the property, it casts serious doubt on the entire operation.

Two options: extend your tax returns so you can show your real estate tax professional that the rental property did return to its intended purpose after the second round of renovations (in our example). Alternatively, you file the current tax return without the cost segregation study, and do a look-back cost seg with a Form 3115 / IRC Section 481(a) adjustment.

But to expect your tax professional to play along with a check-the-box, form-over-substance approach is not one of them, unless there is solid evidence of regular and continuous actions that resemble a business. Ok, stepping down from the soap box.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

The closing disclosure or settlement statement, and what old timers still call the HUD-1, has several items that have varying tax consequences. Here is a summary of the most common ones using the Consumer Finance Closing Disclosure template. In certain jurisdictions or transactions, a settlement statement is crafted by an attorney or title agency, and is not consistent. As such you must pick through it to determine what are acquisition costs, what are current years expenses, what are neither and what are complete mysteries.

A lot of this comes from IRS Publication 523 Selling Your Home, IRS Publication 530 Tax Information for Homeowners, IRS Publication 527 Residential Rental Property, and IRS FAQs from their website. Some of this is also just common accounting asset basis stuff. Here we go-

Loan Costs

Loan costs are amortized over the length of the loan term. Should you refinance, any remaining amount is immediately expensed and deducted as an operating expense (yet still limited by passive activity loss limitations if applicable). These include-

• Section A. Origination Charges which includes points, and application and underwriting fees. You might also see mortgage insurance premiums and mortgage broker fees.
• Section B. Services Borrower Did Not Shop For which includes appraisal, credit report, flood, document preparation, tax monitoring and tax status fees.
• Section C. Services Borrower Did Shop For which includes pest inspection, survey and title fees.

Be alert! At times you pay for things directly and outside of closing, such as an appraisal or application fee, and it is not recorded or not recorded correctly. Also, lender credits which appear in obscure places will reduce your overall loan costs.

Points are a fancy way of saying accelerated mortgage interest. Unlike a primary residence or second home where you can deduct points alongside mortgage interest, for rental properties, points are considered loan costs and amortized over the length of the loan. Sorry.

Section E. Taxes and Other Government Fees

These fees include recording fees, and transfer taxes (stamp taxes) and similar fees. People hear the word tax, and immediately think it can be deducted like property or real estate taxes, or sales taxes. Transfer taxes are specifically called out by the IRS as non-deductible. Rather, all these taxes and government fees are considered acquisition costs, and depreciated over 27.5 or 39.0 years, and cannot be accelerated.

Section F. Prepaids

Often a lender will ask that several months’ worth of insurance and property or real estate taxes be paid ahead of time. Under Treasury Regulations 1.263(a)-4(f) there is a rule called the 12-month rule. This allows you to deduct in full an amount where the benefit received from paying the expense spans two tax years.

Here is the exact wording-

(f) 12-month rule-

(1) In general. Except as otherwise provided in this paragraph (f), a taxpayer is not required to capitalize under this section amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of-

(i) 12 months after the first date on which the taxpayer realizes the right or benefit; or

(ii) The end of the taxable year following the taxable year in which the payment is made.

There is a bit of a head-scratcher with prepaid property or real estate taxes on a rental property purchase since the general position of the IRS is that the tax must be assessed and paid for it to be deducted. The 12-month rule above does not mention the words assessment or obligation. The lender requiring you to prepay your property taxes in itself does not mean the taxes were assessed. However, these are mostly timing issues with the county and most taxpayers safely deduct prepaid property or real estate taxes.

The other head-scratcher is a prepaid expense that is paid in one year, but the rental property does not go into service (ready and available for occupancy, and held out for rental use through advertising and related efforts) until the following year. These situations require more discussion.

Section G. Initial Escrow Payment at Closing

These are amounts that initially fund your escrow account with the lender. They cannot be deducted, and they are not added to the acquisition costs. They look super attractive since they have labels such as insurance or property taxes or interest which are generally tax deductible.

Section H. Other

This is where the fun begins. HOA processing fees, inspections, surveys, home warranty fee, real estate commissions, attorney fees, notary fee (not associated with the loan) and title insurance including ALTA endorsements are generally considered to be acquisition costs and depreciated accordingly.

There are some odd ducks out there such as HOA capital contribution- this is similar to initial escrow funding and generally it not deductible nor capitalized as an acquisition cost.

Acquisition Costs

Don’t forget about your acquisition costs that were paid outside of closing such as travel, lodging, legal and professional fees, meals and other related searching and acquisition costs. See our rental property acquisition costs on page 70 for more information.

Seller Credits and Debts

At times the seller will provide a general credit. One of the most common sources is a problem found on inspection. For example, there is damage to the deck where a bunch of boards are rotted, creating a safety hazard. The lender is agnostic, but you need to repair the deck before you can put the rental property into service.

One option is to have the seller make the repairs- but this takes time, and you might not have the project oversight you desire. The other option is to ask for a seller credit, and you make the repairs (or improvements) directly after closing. Many buyers opt for the second option because they can control the entire process and not take unnecessary delays in closing.

A seller credit is a general reduction in the basis of the property, and typically reduces the amount allocated to the building.

According to IRS Publication 530 Tax Information for Homeowners, “any amount the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, cost for improvements or repairs, and sales commissions” will be added as acquisition costs.

Property or Real Estate Taxes

Given the purchase timing within the calendar year as compared to when the county collects property or real estate taxes, the seller might be required to credit you the amount of taxes that they were responsible for but have not paid. If you pay the taxes later but in the same tax year, you will reduce the expense by the amount of the credit provided by the seller.

Should the credit exceed the amount of taxes paid, you essentially end up with a negative expense which in a roundabout way would be considered income. Rather, if this situation arises, the excess would be a reduction in your rental property basis and usually applied against (reduce) acquisition costs.

Also, keep in mind that several states collect property or real estate taxes in arrears. This means that taxes levied for 2025 are due and collected in 2026. This can throw off the first year and compound the seller credit problem just described.

Converting a Residence into a Rental Property

Since there are slight differences between buying a residence and buying a rental property in terms of tax deductions (for example, mortgage points) these situations get tricky when recording the rental property and associated assets on a tax return. Each conversion is unique, and needs to be carefully reviewed to ensure the basis of the rental property captures everything but also do not capture items that were otherwise deducted or deductible.

See converting primary residence to a rental section for more information.

Carrying Costs

You might choose to capitalize certain expenses that are otherwise deductible. You might do this since you are unable to take advantage of the tax deduction today, for a variety of reasons, but you will be able to in the future.

Here is a blurb from IRS Publication 527 Residential Rental Property–

Deducting vs. capitalizing costs.
Don’t add to your basis costs you can deduct as current expenses. However, there are certain costs you can choose either to deduct or to capitalize. If you capitalize these costs, include them in your basis. If you deduct them, don’t include them in your basis.

The costs you may choose to deduct or capitalize include carrying charges, such as interest and taxes, that you must pay to own property.

For more information about deducting or capitalizing costs and how to make the election, see Carrying Charges in sections 263A and 266.

We don’t want to go too far down this road, but you should be aware that might be beneficial in certain scenarios. IRC Section 263A is mandatory and generally applies to construction whereas IRC Section 266 is elective.

See our capitalizing construction mortgage interest section for a deeper look into carrying costs.

Summary of Closing Disclosure Items

The bottom line to all this madness is summed up in four bullets-

• The amount is a loan cost and wouldn’t exist without a lending environment, and therefore is amortized as a loan cost.
• The amount is an acquisition cost and wouldn’t exist without the transaction itself, and therefore is depreciated.
• The amount is an expense, and generally deducted as such given the constraints previously discussed.
• The amount is an escrow or pre-funding payment.

When in doubt, call the amount an acquisition cost unless it is clearly an escrow or pre-funding payment.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 3 focuses on setting up your rental property correctly from the start to ensure tax compliance, proper housekeeping and maximum rental property tax deductions. It begins with what to do immediately after acquiring a rental—such as determining when the property is “placed in service,” separating building from land value (important for depreciation and cost segregation), and capturing all acquisition-related costs (the often forgotten tax reduction chore). This foundational setup is critical because it defines when depreciation begins and what expenses are deductible. The key? Placed in service! Say with us, “buy today, in-service by close of business.”

Ok, we took that too far.

The chapter also explains how to categorize and allocate common rental launch expenditures like loan fees (also forgotten frequently), appraisals, inspections, furnishings and supplies. We discuss what gets capitalized, what can be expensed, and when, with a lot of attention on closing disclosure or settlement statement matters. The chapter also covers best practices for asset categorization and the advantages of separating multi-unit properties into distinct tax return fixed asset entries for flexibility and the mechanics of moving your rental property into an LLC.

This chapter is short and sweet. The introduction might be like a movie- all you need is the trailer.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

When you setup your asset on the fixed asset listing of your tax return, you will likely have at least two but usually three asset buckets-

• Land
• Building, including Acquisition Costs
• Loan Costs
• Certain Start-Up Costs (possibly)
• Improvements (to get things launched)

You might have another bucket for furnishings (so you can accelerate depreciation, but there is a danger), and you might even see the need to bifurcate building and acquisition costs as separate assets to tie out the numbers.

The word “fixed” might throw you off. Fixed assets are long-term assets. This means the assets have a useful life of more than one year. Fixed assets include property, plant, and equipment (PP&E) and are recorded as such on your tax returns (and financial statements should you have a balance sheet).

We’ll talk about these in turn except start-up costs which are discussed in a later section.

Intro to Depreciation

Before we get too far down the asset setup, let’s briefly discuss depreciation. Generally, real estate investors like depreciation since it is a cashless tax deduction. Other tax deductions such as advertising, management fees, utilities, HOA dues, repairs and maintenance, among many other things, require cash. Sure, they are a tax deduction, but cash is leaving you. To save $2,400 you must spend $10,000 assuming a 24% marginal tax bracket.

Depreciation is a cashless deduction. The principal portion of your mortgage payment requires cash and is not a tax deduction. These two don’t perfectly offset each other of course, but it does help.

Depending on the structure of the rental property purchase (cash versus loan versus investor), you could easily have a positive cash flow and a tax loss. Said differently- you could earn cash without paying taxes (at least not today since some taxes might be deferred and recaptured upon sale). The primary contribution to the positive cash tax loss situation is depreciation.

Sidebar: Upon sale of your rental property, depreciation is recaptured which means you might pay taxes back to the IRS on your prior depreciation deductions. In other words, depreciation is a little IOU to the IRS. Sure, a 1031 like-kind exchange can defer this recapture problem. At times you want to worry about next time, next time (kick the can sort of thing).

We like to have it, play with it, accelerate it, give it nicknames, maximize it, etc. This is why depreciation is such a popular topic. In some real estate investor homes, we bet depreciation has a place setting at dinnertime.

Land

Land cannot be depreciated, and as such it must be split out from the other assets. The question becomes- what portion of my purchase price is the land value? Good question!

The easiest way to determine this is using the county assessor’s ratio. Let’s say you purchase a rental property for $500,000, and according to the assessor’s data the parcel is assessed at $45,000 land and $180,000 building for a total of $225,000. In this example, land is 20% and using this ratio, you could assume that land is $100,000 on your $500,000 purchase leaving $400,000 as building.

Property tax assessments are not always accurate. Poke around the records of other properties nearby and see if things make sense. Assessments might not include a new addition or a finished basement, or other things that increase the building portion of the overall value. If you are obtaining an appraisal, asking for the breakdown might prove worthwhile.

We expand a bit more on the land versus building allocation in our cost segregation study section. Actually, a lot more- you should check it out in a few pages.

Condominiums become a conundrum since the homeowner’s association might own the land or it is on some weird land lease with the county or state. In some cases, the land is held as tenants in common with all the owners. Here is something to think about-

According to Colorado Homeowners Association Law, a law firm in Colorado, and their “Whose Land is it Anyway? And Why do we Care?“ article-

The Colorado Common Interest Ownership Act (CCIOA) defines two different types of common interest communities – condominiums, and planned communities. Planned communities are anything that is not a condominium. A condominium is a common interest community in which portions of the property are designated for separate ownership (the condominium units themselves), and the remaining property is designated for common ownership solely by the owners. In other words, the owners own the common property, typically as tenants in common with each other, and the association doesn’t have title to any of the common area property. On the other hand, in a planned community, title to the common areas is typically conveyed to, and held by, the association.

Gee whiz, right? Certainly, the purchase price of a condominium contains some land value- the same condo building in Malibu as in Toledo, Ohio will have vastly different values based on location alone. Is location the same as land? Perhaps.

However, most tax professionals would agree that assigning $0 or some super nominal amount such as $100 to land favors the taxpayer in the form of depreciation. In other words, more of the rental property is allocated to building, which is depreciable, than land, which is not. A quick review of the assessor’s data might provide some insights even with condominiums.

Rules of thumb are hard to come by. Two homes with identical statistics such as size, bedrooms and age can have wildly different ratios between building and land simply based on location which includes the relative demographic income. As such, a ratio in a small Texas town might not work the same as a high-density segment of Denver, Colorado.

Building and Acquisition Costs

We discussed acquisition costs in a previous section. Some tax professionals will tease out the acquisition costs and list two assets- the building itself less land allocation, and acquisition costs. The intent in part is to signal that acquisition costs have been accounted for properly on the fixed asset listing.

Loan Costs

See previous section on Rental Property Acquisition Costs. Been there. Done that.

Furnishings

This is a can of worms. If you purchase a rental property that is furnished (for example, a turnkey short-term rental), you might be inclined to separate a chunk of the purchase price, allocate it to furnishings, and then list the grouping as a separate asset on your fixed asset listing. The primary motivation would be to accelerate the depreciation of the furnishings. This might be bad for two reasons-

• For example, you have $25,000 listed as furnishings. You replace the couch. Now you must go through the rigmarole of a partial asset disposition where you unbundle the asset and dispose of the couch. You might trigger depreciation recapture based on the fair market value of the old couch (let’s say you sold it for $250). The new couch is likely under $2,500 and therefore would be immediately expensed wiping out the depreciation recapture, but what a big ol’ hassle, no? We will review the $2,500 de minimis safe harbor and other safe harbors in a later section.
• Many local cities and counties impose a tangible personal property tax on each piece of equipment (Yes, furnishings count as equipment) that is used to produce income. By not tracking furnishings directly on your fixed asset listing of your tax return, you might mitigate this tax.

Another issue becomes separating the rental property acquisition into two deals- real property and personal property. This in itself is not challenging, but many real estate investors want to finance as much as they can, and a separate deal might require separate cash.

Not all is lost- you might be able to have a detailed listing of the furnishings complete with fair market values that can be used to leverage the de minimis safe harbor election (more on this in a bit) and be immediately expensed. No fixed asset listing. All the deduction. No calories. All the taste.

Multiple Units

When you purchase a duplex, a triplex or a 4-unit, or even a home with an auxiliary dwelling unit (ADU) or converted garage / attic, it is ideal to split these into multiple assets on your fixed asset listing. There are three primary reasons-

• You might want to take one unit offline to renovate. You might also move into a unit directly which then not only takes the rental property offline, but also takes it out of service. By having separated units listed as assets, you can put various units into service and take them out of service very easily without a bunch of math gymnastics. Many tax professionals and DIYers do not spend the extra few minutes to set this up but they should. See our taking the rental out of service section for more information.
• Let’s say you have a rental property that also has an ADU. One day you wake up and want to make the ADU a short-term rental. By already having the assets split on your prior year tax returns with assigned unadjusted cost basis from the original purchase, you can create another activity, and then easily move the asset plus its associated historical data (generally you need two activities since one will be a long-term rental and the other will be short-term).
• Along similar lines, there might be better cost segregation results on each unit. When a cost segregation study is done, additional assets are added to your fixed asset listing and are connected with building. As such, keeping things separated is neat and tidy.

While the second reason is a bit more obscure, setting up your asset listings to be flexible for what the future might bring is good housekeeping (but not necessarily required… like flossing). Here is an example of a lovely rental in Amityville-

108 Ocean Avenue – Building + Acq Costs
108 Ocean Avenue – Converted Garage
108 Ocean Avenue – Loan Costs
108 Ocean Avenue – Land

A lot of house hackers, where you live in a unit or a portion of the house while renting out the remainder, will set up their assets in this fashion as well. Fun!

Basic Depreciation and Amortization Life

Here is a quick summary of the basic depreciation and amortization life schedules-

• Residential buildings- 27.5 years.
• Commercial buildings and short-term rentals- 39.0 years.
• Acquisition Costs- follow the primary building above but as amortization.
• Loan Costs- life of the loan, usually 30 or 15 years for residential, and 20 or 25 years for commercial.

By Jason Watson, CPA
Posted Monday, August 5 2024

There are several benefits of owning your rental property in an LLC as we’ve discussed in a previous chapter. Here is a recap-

• Separate checking account for compartmentalization.

• Anonymity.

• Orderly ownership (wealth) transfer baked into the Operating Agreement side-stepping Wills and Trusts.

Downsides with an LLC owning a rental-

• Additional tax return and the associated preparation fees in a multi-member LLC environment (unless you are in a community property state).

• Annual Secretary of State filings. Some states are cheap, some are insanely expensive.

• Franchise tax or some sort of LLC fee charged annually.

Contrary to what your produce clerks says, you don’t get-

• Extra tax deductions.

• Tort liability protection or iron-clad asset protection.

Again, please refer to our expanded section on the benefits of putting a rental into a multi-member limited liability company taxed as a partnership.

Basic Steps

What are the basic steps to get this accomplished? The first step is to contact your lender. Because they have your title on lockdown, you will need to coordinate with them. Since 2010 or so, this is a much-accepted common practice and the hurdles are very few and small.

The second step is to connect with a title company to perfect all the recording magic. An attorney can likely handle this as well, and likely can bundle the LLC formation, Operating Agreement drafting for your specific needs including estate planning and then the ultimate title transfer.

Other Considerations

Keep in mind these other considerations when you move your primary rental property into an LLC-

• You might trigger transfer taxes with the county or local tax jurisdiction including HOAs.

• Your historical depreciation and fixed asset listing from your individual tax return (Form 1040) just slides on over. You do not reset your depreciation or get a step-up in basis.

• You are contributing property to the LLC. It is unlikely this will be viewed as a sale, but be aware that you might accidentally trip this wire (again unlikely, especially if you use qualified professionals such as attorneys, title agents, etc.).

• Leases, permits, contracts and utilities will need to be updated with the name of the LLC. Banking information for auto-pay will also need updating.

• If your LLC is owned by you and your spouse, you might suddenly create a partnership tax filing obligation depending on your state (community property versus common law property). This is not all bad. There might be some benefits, and we discuss them in our section on rental property partnerships.

• WCG CPAs & Advisors usually recommend naming the LLC after the address such as 1234 Main Street LLC.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

The question comes up often- what costs can I deduct in the acquisition of a rental property. There are several, but the rub is that most expenditures associated with purchasing a rental property are considered costs (versus expenses) and are depreciated or amortized accordingly. As such, you get a deduction for acquisition expenditures, but it takes time.

Travel Expenditures

Travel expenses associated with start-up and acquisition have four important distinctions-

• Start-up travel costs, before a specific rental property is identified, are generally immediately deductible under IRC Section 195. There are limitations. See our start-up costs sections for more information.

• Acquisition travel costs including meals in a new geographical location. These are generally added to the purchase price of the rental property, and depreciated accordingly. Yuck.

• Travel expenses for additional rental properties in the same geographical location are generally immediately deductible as operating expenses. Yay.

• Travel costs, after you already have a rental property but in a different geographical location, are considered a new business venture and therefore would be considered start-up costs if you have not identified the target rental property. Once identified, the travel costs change to acquisition costs.

So, travel expenditures could be start-up costs, acquisition costs or operating expenses depending on timing, geography and whether you already own a rental property.

Sidebar: Did you also notice the word change between expenses and costs? Costs and expenses are similar concepts, and they’re sometimes used interchangeably. However, a cost typically refers to the price paid to acquire an asset such as a rental property, while an expense is an ongoing expense or associated with operations. This also aligns with the term cost basis when speaking about assets.

Let’s run through some examples. The first example highlights start-up costs so you can see the difference- you travel to Miami four different times looking at various rental properties each time, and you eventually identify and close on a nice condo. Prior to identifying the target business or in this case, the rental property, these expenses might be considered start-up expenses and therefore deductible.

IRC Section 195(c)(1) reads in part-

We expand on start-up costs in our getting the rental business launched section.

Next example- you’ve identified a nice rental property, and you travel to Miami four different times to a) do an initial walk-through, b) be present for inspections, c) sign-off on a seller repair and contingency and d) final walk-through and closing. The costs associated with these four trips to Miami would be considered acquisition costs (not start-up expenses) and added to the purchased rental property’s cost basis and depreciated accordingly.

Next example- you travel to Miami to look for and purchase another rental property. This is considered a business expansion, and travel expenses are considered operating expenses. This is an important distinction since these expenses are a) not considered start-up expenses which have limitations and b) not added to the purchase price as acquisition costs with the slow tax benefit of depreciation. Rather, they are generally immediately deductible.

Final example- you’ve had your fill of Miami and decided to pursue a rental property in Key West. This is likely to be considered a new business venture and therefore start-up expenses might be leveraged but you also have the downsides of adding acquisition costs to the purchase price and subsequent depreciation. In other words, the travel costs associated with Key West would not be operating expenses like the example above.

As a summary, travel expenditures could be start-up costs, acquisition costs or operating expenses depending on timing, geography and whether you already own a rental property. Here is a table that might be helpful as well-

New Location	Property Identified	Type	Deduction
Yes	No	Start-Up Costs	Deducted (limits)
Yes	Yes	Acquisition Costs	Depreciated
No	No	Operating Expense	Deducted
No	Yes	Acquisition Costs	Depreciated

We expand on all this in our rental property travel deductions section.

What if you never purchase a rental property or make a real estate investment during the tax year? IRS Publication 535 Business Expenses reads in part-

If your attempt to go into business is unsuccessful. If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories.

1. The costs you had before making a decision to acquire or begin a specific business. These costs are personal and non-deductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility.

2. The costs you had in your attempt to acquire or begin a specific business. These costs are capital expenses and you can deduct them as a capital loss.

You have two scenarios here. Let’s look at some examples- you spend $4,000 on a real estate investment course, but you never identify the target business. Meanwhile December 31 comes and goes, and you fall out of favor with real estate. This $4,000 would fall under the first scenario, and therefore would not be deductible.

You identified a rental property, and you spent $4,000 on travel and legal fees. However, the deal falls through and you do not purchase another property. This would fall under the second scenario, and become a capital loss subject to those limitations.

What if you spent $4,000 on travel and legal fees in November, identified your target business or rental property in December, filed your tax returns in February with a nice $4,000 tax deduction because WCG CPAs & Advisors is wicked fast, but the deal falls through in April? Oh boy, a discussion certainly needs to be had. What if another rental property in the same area is identified and purchased?

For fun, let’s go back and spend $4,000 on a real estate investment course. However, you already own and operate a rental property. This could easily be considered an education expense that is tax deductible since it improves your current work skills. If you were launching another rental property purchase or some other real estate business, this same $4,000 could be start-up costs. It’s all a matter of perspective.

How about this one- you already own a nice short-term rental property in Miami but you also are snooping around in Vail. Why not, right? You spend $4,000 on travel and legal fees to check out the area but have not identified the target property to purchase. Time goes by, and you back out of the Vail market. This $4,000 is lost as a tax deduction since you never started your business (purchased a rental property), nor can you consider it an operating expense for your current short-term rental for lack of business connection.

Our apologies for the slight digression.

Meals During Acquisition

In playing off our travel deduction examples in another section, let’s say you’ve identified a nice rental property in Miami. You travel there four different times to a) do an initial walk-through, b) be present for inspections, c) sign-off on a seller repair and contingency and d) final walk-through and closing. You must eat, right?

Assuming that your trips to Miami required overnight rest, or that you met with a business associate (real estate broker or prospective tenant), and happened to eat a meal during the meeting, the meals associated with these four trips to Miami would be considered acquisition costs (not start-up expenses) and added to the purchased rental property’s cost basis and depreciated accordingly.

This aligns with the general premise that a real estate investor or rental property owner might incur costs that facilitate a transaction, and they include such things as commissions, advertising fees, appraisal fees, meals, travel, and professional fees.

Closing Costs

Closing costs are commonly forgotten on rental property setups. Approach this by asking yourself what costs would I have incurred if the purchase was made with cash, and without borrowing. Those costs typically include abstract fees, charges for installing utility services, legal and recording fees, surveys, transfer taxes, title insurance, and any amounts the seller owes that you agree to pay (such as back taxes or interest, recording or mortgage fees, sales commissions and charges for improvements or repairs). This list is straight from the IRS website.

The amounts above are considered acquisition costs and are added to the cost basis of the rental property. Easy.

Loan Costs

What about loan costs? The costs beyond a cash deal? Unlike your primary residence, where you can only deduct qualified points and interest, you can amortize all costs associated with obtaining a new mortgage for your rental property over the life of the loan (usually 30 years). Common loan-related expenses include points, loan origination and loan assumption fees, mortgage insurance premiums, application fees, credit report fees and appraisal fees (if required by the lender).

Quick example. $3,000 in loan-related costs amortized over a 30-year loan would be $100 per year (and therefore deducted). Amortization is similar to depreciation but relates mostly to intangible assets such as goodwill, patents, copyrights, and loan costs.

Be careful of impound and prepaids on the closing disclosure or settlement statement. If you are asked to impound 6 months of mortgage interest or property taxes, these are not loan costs.

Other Acquisition Costs

Here are some more acquisition and closing costs that are commonly overlooked-

• Application fees, and similar expenses.

• Property appraisals and inspections including architectural, engineering, environmental, and geological services.

• Legal and accounting fees including tax advice to review offers, purchase or sales agreements.

• Costs to obtain regulatory approval or secure permits (think short-term rental permits).

• Cost of services provided by a qualified intermediary in a like-kind exchange.