Chapter 11 Frequently Asked Questions

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here are some FAQs you might find helpful as a chapter summary-

Can I deduct expenses incurred immediately after closing but before placing the rental property in service?
Generally no. If the property is not yet ready and available for rent, expenses like mortgage interest, taxes, insurance, and utilities are not deductible as rental expenses. According to IRS Revenue Ruling 99-23 and IRC Section 195, these costs are considered pre-rental and must be capitalized or may be partially deductible under other provisions (e.g., property taxes on Schedule A if applicable). Yuck.

Can I deduct mortgage interest during a renovation?
Not if the property is not in service. You may elect to capitalize it under IRC §266 instead. You will find yourself in this situation typically if you buy a rental, never make it available for rent, and immediately start renovations.

What expenses can I deduct if I start renovations after the property has already been a rental?
If the property was previously placed in service and you continue to hold it for the production of income, you may deduct ordinary and necessary expenses under IRC §212—even if no income is earned during the renovation period. This includes mortgage interest, taxes, insurance, and utilities, provided there is no personal use.

What’s the tax strategy to maximize expense deductions for immediate renovations?
To ensure expenses are deductible, first place the property in service—meaning it is ready and available for rent—and then take it offline for renovations. This sequence meets both the “in-service” and “held for production of income” standards under IRC Section 212 and Treasury Regulations Section 1.46-3(d)(1)(ii). Yay!

What are “carrying costs”?
Carrying costs include mortgage interest, property taxes, utilities, insurance, and maintenance costs incurred while the property is not yet in service.

Do I have to capitalize interest and taxes on an idle property?
No. It’s optional, but capitalization might be more beneficial when the rental property is offline and not generating income. Typically, most rental property owners will expense it which might be subject to passive activity loss limitations.

What happens when I change a rental from long-term to short-term?
You switch from 27.5-year to 39.0-year depreciation. However, this is typically not a change in accounting method.

Can I use bonus or Section 179 depreciation during a change in use?
No. Neither bonus depreciation nor Section 179 can be used in the year of change-in-use.

Neat, what is a change in use?
The most common are going from long-term to short-term, and vice versa. In the context of bonus depreciation and Section 179 above, going from a primary residence to a rental property is a change in use technically, but the asset was not placed in service prior to change in use (so, you are good with Section 179 and bonus).

Is depreciation recapture triggered by a use change?
No. It is not triggered until the asset is sold or taken out of service (its intent is no longer to produce income such as moving back into as a home).

When is a rental considered “out of service”?
When it is no longer held for the production of income, such as converting it into a second home or letting family live there for free. Didn’t we just say that?

Can I deduct expenses while a property is out of service?
Only expenses related to holding the asset for sale (e.g., property taxes). No operational deductions are allowed.

Does renovation take a property out of service?
No, as long as your intent to produce income remains and will remain after renovations (i.e., putting the rental back online), and the property is not being used personally.

Can I increase my basis after buying out a partner?
Yes—by filing an IRC Section 754 election, you can step up your inside basis to reflect your additional purchase price. Very common. Often over-looked by tax professionals.

Does the 754 election affect depreciation?
Yes. The step-up amount is depreciated, creating an additional deduction for the acquiring partner.

What is the difference between idle and vacant property?
They’re often used interchangeably, but technically, idle means not in use yet still held for producing income. Vacant means available but unoccupied. Idle is most often used with machinery and whatnot, whereas the context of rental properties usually use vacant.

Are rental operating expenses deductible if I can’t find tenants or guests right away?
Yes, but only if your efforts to rent the property are genuine and documented. You must demonstrate that the property is held out for rental use. If your actions suggest minimal or insincere attempts to find renters (as in Meredith v. Commissioner), the IRS may disallow those deductions.

Can I claim depreciation on vacant rental property?
Yes, if it remains held for income-producing purposes, like during tenant turnover or repairs.

What if I plan to sell me vacant rental property?
If it’s no longer held out for rent use (i.e, the production of income) and is instead held for sale, depreciation and operational deductions might be limited.

What is a Delaware Statutory Trust (DST), and how is it used in real estate?
A DST is a legal entity that allows multiple investors to co-own fractional interests in real estate. DSTs are commonly used in 1031 exchanges to defer capital gains taxes. They can help meet tight identification deadlines, avoid debt qualification requirements, and serve as backup options when replacement properties are limited.

What are the downsides of investing in a DST?
DSTs offer limited control and liquidity. Investors cannot make property-level decisions and may find it difficult to exit the investment early. DSTs are regulated as securities, so they require careful due diligence and are not ideal for hands-on investors seeking flexibility or active involvement.

Can I exclude the gain on an ADU when I sell my primary residence?
Not entirely. Under IRC Section 121 and Treasury Regulations Section 1.121-1(e), you generally cannot exclude gain from the sale of a separate structure (like an ADU) used for rental or business purposes, unless you lived in it for at least 2 of the last 5 years before the sale. Lots of rules.

How is gain calculated when part of my property was used as a rental?
You must allocate both the sales price and the cost basis between the residential (personal use) and nonresidential (rental/business) portions. Gain on the personal residence may be excluded under Section 121, but gain on the rental portion is taxable and subject to depreciation recapture. More rules and possibly complex and unfavorable math.

Is there a way to reduce the taxable gain on the rental portion?
Possibly. You can obtain an appraisal or broker’s price opinion to assign a smaller value to the rental portion (like an ADU). While this won’t eliminate the tax, it may reduce the allocated gain. However, it must be reasonable and supportable.