LAURENE H. YOUNG, RMP, REALTOR
Young Hawaii Homes, Inc.
2011 President, Oahu Chapter
National Association of Residential Property Managers
Q. I just bought a rental property. It needs some work before I get a tenant. What is the difference between an improvement and a repair? What are some basic things I should know about deductions and reporting requirements?
A. Rental property owners are allowed many tax deductions and/or depreciation on property associated with their rental business. These are general guidelines and there are exceptions and conditions to many items, so please consult your tax advisor for specifics in your case.
Most landlords are “cash basis” taxpayers. As such, they would normally report any income in the year they receive it, even if it is paid in advance of the due date. Income not only includes the monthly rent received, but also any fees you charge to your tenant for cancellation of leases, late fees, any of your expenses paid by your tenant, or the value of any services provided by the tenant in lieu of rent. Do not include the security deposit in your income if you plan to return it to the tenant at the end of the lease.
You normally claim deductions in the year in which you pay the expense. Expenses include repairs (described below), advertising, association dues, insurance, mortgage interest, property taxes and fees paid to your property manager, attorney, or accountant related to the rental business. You can deduct expenses (keep track of your mileage) to travel to your rental unit if the purpose is directly related to managing the rental unit. If your rental unit is located outside your local area, expenses might also include airfares, lodging and meals. If you also include personal travel with this trip, you would only be able to deduct a portion of your trip. The expenses qualify if they are ordinary and necessary to the operation of the rental property, are directly related to the operation of the rental property, are reasonable and are current. You cannot claim a deduction for uncollected rent since you did not claim that income.
A “repair” is something done to keep your property in good operating condition or to restore the property to its original condition. It does not materially add value to the property and includes painting and repairing broken items or leaks. You are able to deduct the cost of repairs in the year you paid the bill.
An “improvement” is something that adds to the value of the property or prolongs its useful life, such as a new roof, carpeting or new appliances. Improvements to the property are handled through depreciation. You begin depreciation in the year your rental property is first placed in service for the purpose of producing income or in the year when an improvement, such as a new appliance, is first ready for use in the rental property. Only a percentage of these expenses is deductible each year. Depreciation depends on the cost basis of the property and must be done over the useful life of the item. For example, the rental property is depreciated over 27.5 years while the refrigerator or carpet might be depreciated over 5 years. You can depreciate the property if you own it, it is used as a business or income-producing activity, it has a determinable useful life and is expected to last more than one year. You cannot depreciate the value of the land since it does not wear out. You stop depreciating a property when you have fully recovered your cost or it is retired from service, whichever occurs first. If you sell your property, convert it to personal use, abandon the property or the property is destroyed, you must stop depreciating it. Depreciation also reduces your cost basis when you sell or exchange your property.
There are several methods for depreciating a property and you should consult your tax advisor for the method you should use. They will be able to determine the cost basis of the property you bought and calculate the amount of depreciation each year. This can be a complicated procedure that is best left to the tax professional. Make sure to keep receipts and other documentation in case of an audit.