Expenditures – Part 2
Expenditures – Part 2
In a recent newsletter (Expenditures – Part 1) we discussed some basic principles regarding expenditures including those that (1) may be deducted in the year made, (2) must be capitalized, (3) must be amortized, and (4) must be added to basis. In this newsletter we continue the discussion of expenditures by considering in more detail some of the specifics related to deductible expenditures.
As stated in Part 1, 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.
Those expenditures that may be deductible in the year paid include the following:
- Advertising and other marketing of the rental property
- Cleaning & maintenance of the property
- Utilities serving the property
- Insurance of all types related to the property
- Taxes of many types related to ownership and operation of the property
- Rental payments to others for equipment or real estate related to the rental property
- Employee overhead
- Interest on loans, whether for the subject property or for equipment used for the property
- Mortgage Points (although not all)
- Management fees or leasing commissions paid
- Tax return preparation fees directly related to the property
- Travel expenses related to the property or management thereof
- Auto or other local transportation expenses related to management or maintenance
Some of these items require discussion beyond what was said in Part 1 of this series because they are more likely than others to raise issues in income tax audits.
Repair & Maintenance Expenses
Expenditures for repairs and maintenance, both labor and materials, are deductible in the year paid. Items charged to a credit card can usually be deducted n the year posted to the card account even though paid in the next year or over multiple future years.
Whether an expense is a repair or maintenance is usually immaterial and some events can be considered to be one or both. A repair expense is usually considered an expense incurred in order to restore an item or a system to its previous condition. As examples, replacement of the washer in a leaking faucet or replacement of a relatively small number of shingles would usually be considered to be repairs. A maintenance expense is usually incurred in order to keep a rental property component in good condition. For example, interior and exterior painting expenses are usually deductible in the year paid.
Capitalized Expenditures – Improvements
You must capitalize rather than deduct some expenditures. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.
- Business start-up costs
- New business assets
- Improvements and restorations
For an ongoing rental property, improvements are usually the most common expenditure that must be capitalized. An improvement is work that adds something new to an existing property or makes it better than it was. It is an expense that is incurred to make the property more valuable or to allow for increased rent. Further discussion of improvements and restorations will be included in Part 3.
You cannot deduct the cost of improvements. You must separate the costs of repairs and improvements and keep accurate records of each separately. The cost of an improvement must be capitalized. You recover the cost of improvements by taking depreciation as if the improvement were separate property. You will need to know the cost of improvements when you sell or depreciate your property, as the cost less the portion depreciated prior to sale are added to the basis of the property, reducing the gain from the sale.
Employee Overhead
As you probably expected, not only is the salary or hourly wages of employees who perform management and maintenance work deductible, but all overhead costs associated with those employees are also deductible. Included in such overhead is unemployment insurance, workers’ compensation insurance, the employer one-half of Social Security and Medicare taxes, and health insurance premiums paid by the employer.
However, both wages and overhead associated with improvements would have to be capitalized along with materials and other costs of doing capital improvements just as for capital improvements made by independent contractors.
Interest Expense
You can deduct interest paid on a mortgage or other loan related to your rental property. You cannot deduct interest paid in advance beyond the tax year. If you paid $600 or more of mortgage interest on your rental property to any one person or entity, you should receive from the lender a Form 1098 Mortgage Interest Statement showing the interest you paid for the year.
Expenses Paid to Obtain a Mortgage
Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, legal fees, abstract fees, title insurance premium, and recording fees, are capital expenditures that you can usually amortize over the life of the mortgage.
Points – The term “points” is often used to describe some of the charges paid by a borrower to take out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest. Points paid when you take out a loan or mortgage result in original issue discount (OID). In general, the points (OID) are deductible as interest unless they must be capitalized. How you figure the amount of points (OID) you can deduct each year depends on whether or not your total OID, including the OID resulting from the points, is “insignificant.” If the OID is not insignificant, you must use the constant-yield method to figure how much you can deduct.
Loan or Mortgage Ends
If your loan or mortgage ends, you may be able to deduct any remaining points (OID) in the tax year in which the loan or mortgage ends as well as any other costs related to financing that were being amortized. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event. However, if the refinancing is with the same lender, the remaining points (OID) generally are not deductible in the year in which the refinancing occurs, but may be deductible over the term of the new mortgage or loan.
Travel Expenses
You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. This will usually include educational costs related to investing in and managing income properties. You must properly allocate your expenses between rental and non-rental activities. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was the improvement of your property. The cost of improvements is recovered by taking depreciation.
Local Transportation Expenses
You can deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property. Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: (1) actual expenses allocated to business use according to the percentage of miles driven for business compared to total miles driven for the year or (2) the standard mileage rate for the business miles. For 2010, the standard mileage rate cars, vans, pickups, or panel trucks was 50 cents a mile for all business miles and for 2011, the rate is 51 cents a mile.
To deduct vehicle expenses under either method, you must keep records that follow the rules in chapter 5 of IRS Publication 463. In order to determine the percentage of vehicle expenses or mileage that are business related and support the percentage in an audit, it is important that a log be kept. The log should include beginning and ending odometer mileage for each business related trip.
Payment for Goods & Services
Landlords are required by law to provide 1099 forms for payments totaling $600 or more in a calendar year made to unincorporated businesses for services.
Most landlords often use unlicensed contractors and many of these vendors will not qualify as independent contractors under an audit. Furthermore, many landlords do not utilize 1099s as required by law. While 1099s are required for both licensed and unlicensed non-corporate contractors, failure to use 1099s for unlicensed individuals carries greater risk because licensed contractors are much more likely to possess other characteristics that are considered by the IRS when the issue arises regarding whether a worker is an independent contractor or an employee. Without going into all the details about the potential penalties for improper classification, suffice it to say that all items required for employees – including income tax withholding, social security payments, unemployment insurance, and workers’ compensation insurance – are potentially costly items that can include back payment for those items that would have been required for an employee as well as stiff penalties and interest.
While filing 1099s does not make the worker an independent contractor, the fact that the worker received a 1099 and knows the landlord will file the information with the IRS and the state should increase the odds that he/she will report the income on his/her income tax returns and reduce the chance that the worker might file claims for workers’ compensation or unemployment payments, two of the events by which the possible misclassification of workers becomes an issue.