Expenditures – Part 1
Expenditures – Part 1
In a recent newsletter, we discussed which receipts are income and which are not income and when income must be reported. In this newsletter we will begin a discussion of expenditures. Because expenditures can be of different types with different reporting procedures, the subject of expenditures is more complex than the subject of income. Accordingly, the discussion will be spread over several newsletters, starting with some basics in this issue and those expenditures that are deductible in the year paid.
Deduct, Capitalize, Section 179, Amortize, or Add to Basis?
Landlords make lots of expenditures throughout the year related to operating, preserving, and upgrading their properties. Most landlords know that (1) some expenditures may be expensed (deducted in the year made), (2) others must be capitalized and depreciated over the period specified by the IRS, (3) some that would normally have to be capitalized can, with certain limitations, be deducted under Section 179, (4) yet others must be amortized over a particular period, and (5) still others must be added to cost basis, affecting income taxation only in the year the property is sold.
Personal vs. Business
Generally, one cannot deduct personal, living, or family expenses. Those that are considered Schedule A expenses – including the total of primary and second home loan interest and property taxes; those medical expenses and casualty losses that exceed specified amounts; and expenses related to special events – can be effective deductions if the itemized deductions total more than the standard deduction for the given year. However, for an expenditure for something that is used partly for business and partly for personal purposes, the total cost must be allocated between the business and personal parts and you can deduct or depreciate the business part. Section 179 cannot be utilized for property used less than 50 percent in business.
Prepayment
You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods of accounting. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending beyond the end of the current tax year.
Personal use of rental property
If you sometimes use your rental property for personal purposes, you must divide your expenses between rental and personal use. Also, your rental expense deductions may be limited. For a vacation/second home that is rented for a very limited number of days each year, the rules are different.
Partial interest
If you own a part interest in rental property, you can deduct the part of the expenses that is allocated to your interest.
Portion of Property is Rented
If less than an entire property is rented, with the remainder used personally, you can deduct the expenses in proportion to the part that is dedicated to rental use.
Property Rented For Part of a Year
If you convert a personal residence to rental use, you can deduct expenses from the date you change your property to rental use.
When to Deduct
You generally deduct your rental expenses in the year you pay them.
What Is Deductible
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.
For many rental property expenditures, it is easy to decide whether it can be expensed or must be depreciated. As examples, the cost of repairing a leaking faucet can be expensed, while the cost of building a new concrete block wall around the backyard must be depreciated. However, treatment of some expenditures – for example, the repair or replacement of flooring or roofing – is not always so clear.
Vacant Rental Property
If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, as a cash basis taxpayer you cannot deduct any loss of rental income for the period the property is vacant.
Pre-Rental Expenses
You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.
Depreciation
You can begin to depreciate rental property when it is ready and available for rent.
Expenses for Rental Property Sold
If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold.
Uncollected rent
If you are a cash basis taxpayer, you do not report uncollected rent. Because you do not include it in your income, you cannot deduct it. If you use an accrual method, you report income when you earn it. If you are unable to collect the rent, you may be able to deduct it as a business bad debt.