03 June 2017
I see a lot of landlords during tax season. One of the things they frequently have trouble understanding is when their rental property is “placed in service” and/or “taken out of service”. I thought I would write a quick article to address this issue because using the wrong date is costing taxpayers money.
As a depreciable business asset a rental property is placed in service whenever it is placed in a state of readiness and availability for use in the taxpayer’s trade or business (Brown vs Commissioner, TC Memo 2009-171)
Notice that the definition of placed in service does not include used in the trade or business in the definition. The property does not have to be rented to be in service, is just has to be ready and available. For residential rental properties this typically means the date the property was made available to be rented. You can use the date the property was first advertised for rent as the placed in service date. If you use a property manager you can use the date the property management company was contracted for service.
For example, Jimmy placed a ‘for rent’ sign on his property on May 1. On August 7 he signed a lease with, and received his first rent check from, his first tenant. Jimmy’s property was placed in service May 1.
I often see do-it-yourself tax preparers use the date the property was rented as the date it was placed in service. This is costing them money. If Jimmy was preparing his own taxes and he used August 7 as the date the property was placed in service he would have needlessly deprived himself of 3 months of rental property expense deductions for the tax year the house was placed in service.
The placed in service date is also important in determining the tax treatment of certain items of repair and upkeep. Repairs made before a property is placed in service are classified as ‘capital expenditures’. These must be added to the depreciable basis of the property and deducted as depreciation expenses over the lifetime of the property – 27.5 years. Repairs made after a property is placed in service are considered business expenses and can be deducted in the year they are accomplished.
Let’s look at two similar scenarios.
Mary bought a house and placed it in service on April 1. On April 15 she replaced one of the windows in the house. The window replacement cost $400. Because the window was replaced after the property was placed in service Mary can deduct the entire cost of the window on the tax return for the year the window was replaced.
Ed buys a house on April 1. He replaces one of the windows on April 5. The cost of the window replacement was $400. On April 15 Ed places his property in service as a rental property – meaning he made the unit available to be rented. Because the window was replaced before the house was placed in service the cost of the window must be capitalized and added to the depreciable basis of the property. Residential rental properties depreciate over a 27.5 year period. Ed can only deduct $10.30 for the window in the year he had it replaced (($400/27.5)(8.5/12)). The rest of the cost of replacing the window can be deducted over his next 27 tax returns.
Judging from the reactions of some of my clients, Ed is likely to find the tax treatment of his window replacement highly irritating. He is going to wish he had known to place his rental property in service prior to the replacing the window.
Don’t try to get fancy, though. You can’t buy a property, place it in service, and then gut the kitchen for a two-month remodeling project. Remember – part of the definition of placed in service means placed in a state of readiness. A house with no kitchen cannot reasonably be considered to be in a state of readiness.
Taking a property out of service follows a similar logic, but in reverse. When the property is no longer available or ready to be a rental property it is no longer in service. Often people will use the last date the property was actually rented as the last day the property was in service, which can cause them to short themselves on their tax return. Another example:
Terry and Tina have a residential rental property. The tenants move out on April 30. They advertise the property for rent, but they do not acquire new tenants. Frustrated with their experience as landlords, they sell the property on October 15.
The property was taken out of service the day it was sold, October 15. Even though Terry and Tina had the property for sale before that date they also had it available to rent. If they had acquired tenants before buyers they could have easily delisted the property for sale. If Terry and Tina had said the last day the property was in service was April 30 they would have missed the opportunity to claim the rental property deductions for 5.5 months of the year the property was sold. This could result in them paying more taxes than necessary.
There are significant tax benefits to owning residential rental property. There are also some ‘tips and tricks of the trade’ you should know to maximize the tax benefits available to you as a landlord. If you are unaware of those tips and tricks, please give me a call. I am always happy to discuss your situation.