New Brain-Busting Tax Rules for Rental Properties

Someone in Congress decided that 100,000 pages of intricately complex tax law that would cause even the most math-inclined individual’s head to spin just wasn’t difficult enough. It was time to reboggle the brain.

And so a discussion ensued among these formula-loving tax nerds to further complicate the ownership of rental properties by pick, pick, picking at the difference between repairs, which can be written off the year the money is spent versus improvements, which have to be depreciated over many years.

It breaks down like this – if you spend $1,000 on legitimate “repairs,” you deduct $1,000 on your tax return as an “expense,” thus reducing your income and your income tax liability. But if this $1,000 transaction is categorized as an “improvement” it must be capitalized, which means your current year deduction will be reduced to something as ludicrous as $27, and you would get a similar deduction every year for possibly up to 39 years, depending on whether it’s a commercial rental or a residential rental property and further depending on the “useful life” of the improvement.

A new set of laws known as Tangible Property Regulations (TPRs) were passed September 19, 2013. I sat in a tax seminar and listened to the roar of audible groans from my fellow tax pros during the lecture on this topic. We were provided with a nearly indecipherable one page flow chart with a zillion arrows and bubbles.  Well, Congress must have heard the groans all the way to D.C., because next thing you know they extended enforcement of the rules to the preparation of 2015 tax returns, bypassing the original implementation date of 2014.  I guess they figured we needed a year to figure it all out. And they were right.

And now we are into preparation of 2015, and the IRS expects compliance.

I won’t go into all the new nitpicky regulations, which would make this article about 200 pages long. Well, I can’t resist giving you one example. Check this out (from my seminar manual):

“The replacement of an entire roof must be capitalized as an improvement. On the other hand, the replacement of a worn and leaking waterproof membrane on a roof comprised of structural elements, insulation, and a waterproof membrane with a similar but new membrane is not required to be capitalized so long as the membrane was not leaking when the taxpayer placed the building in service.  Likewise, the cost of replacing shingles that became leaky while the taxpayer owned the building with similar shingles is not capitalized.” Head spinning yet? Uh, maybe you better bring your roofer to the tax interview when you’re ready to prepare your 2015 income tax return.

Accordingly, be aware that you will need to provide detailed information to your tax professional, which includes copies of receipts or a description which shows the nature of each repair or improvement to your rental property, including any supplies and materials that you purchase. Merely listing “Repairs - $5,354” will no longer satisfy the due diligence requirements of the tax professional.

If your rental property is mixed use – meaning it’s part vacation rental and part personal use,  you may want to know about a few tax court cases that came down last year to ensure you don’t make the same mistakes these other taxpayers made.

In Van Malssen et ux. v. Comm. the taxpayers made several trips in 2008, 2009 and 2010 to make repairs to a rental unit. But more time was spent vacationing on the premises then was spent on repairs and maintenance. The IRS classified the trips as personal and disallowed all the associated deductions for travel. Be sure to keep a journal of your daily activities when you visit your rental property to make improvements or repairs. Also keep receipts for all supplies and materials.

In this same case, the taxpayers rented the unit to a relative who did not pay fair market value for the lodging. That was also considered personal use and the associated rental expenses were disallowed.

If you rent to a friend or relative, it is imperative that you are able to prove to the IRS that the rent is at fair market value – comparable to other rentals in the area. If audited you should be able to provide a copy of the lease or rental agreement, ads for comparable properties to support the rent you charged, and bank statements showing you collected the rent that was charged on the tenant agreement. You can otherwise lose a valuable rental loss against other income.

If you own a property that you attempted to rent out but were unable to, you may claim the rental expenses as deductions on your tax return. But you better have proof that you actively tried to rent it. You need to retain copies of ads you placed, a journal of the showings, and other documentation to substantiate that you attempted to rent the property. In a case during 2015, Redisch v. Comm, the taxpayers were disallowed rental expenses because they were unable to prove that they had attempted to rent a property that they owned. They had moved to another house and had converted the old house to a rental. But they could not produce an agreement they had signed with a realty company who was retained to assist them in renting the house. The property was rarely shown for rent, and the taxpayers did not actively attempt to rent the house. All rental deductions were therefore disallowed.