Taking The Rental Out of Service

By Jason Watson, CPA
Posted Monday, August 5 2024

There might be several reasons to take your rental property out of service (no longer available for rent) or convert the rental to personal use. Here are some common reasons-

• You need to renovate the rental property (rehab) to garner a different tenant and increased rent.

• You want to sell the rental property but it needs renovations first.

• Your mother is aging and you feel she should move into your rental property until she is ready for assisted living accommodations.

We could go on and on, right?

Deductions When Out of Service to Sell

Please recall our discussion regarding expenses between the closing date and available for rent date where most expenses are not deductible. A similar situation exists when the rental property is no longer held as available to rent.

A real estate investor could argue that a rental property that meets the standard of being a trade or business, continues to do so while the property is being held for sale. Recall the definition of a “trade or business” which comes from common law. The Supreme Court has interpreted “trade or business” for purposes of IRC Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit.

With respects to depreciation, there is some case law supporting this perspective. In Lenington v. Commissioner, Tax Court Memo. 1966-264, the court answered the question, “can petitioners deduct depreciation on poultry buildings after they ceased operating their poultry business but while the buildings were for sale?” The court reasoned as follows-

Since the poultry buildings were not abandoned or converted to personal use prior to 1962, but were involved in a discontinuance of the active conduct of the poultry business, their previously established character as business property was not changed.

However, IRC Section 62(a)(4) reads-

(4) Deductions attributable to rents and royalties.
The deductions allowed by part VI ( Sec. 161 and following), by section 212 (relating to expenses for production of income), and by section 611 (relating to depletion) which are attributable to property held for the production of rents or royalties.

In a 1944 report from the Committee on Finance, Senate Report 885, 1944 C.B. at 877-878-

Similarly, with respect to the deductions described in clause (4), the term “attributable” shall be taken in its restricted sense; only such deductions as are, in the accounting sense, deemed to be expenses directly incurred in the rental of property or in the production of royalties.

1944 was a zillion years ago, however, in a 2001 Ninth Circuit appeal of Strange v. Commissioner, the court affirmed and referenced IRC Section 62(a)(4) in similar fashion by stating in part-

In this case, our task is to interpret I.R.C. § 62(a)(4), providing for deductions from gross income (“above-the-line deductions”). The Tax Court’s construction of this statute involves a question of law subject to de novo review. See Sliwa v. Commissioner, 839 F.2d 602, 605 (9th Cir.1988). Because tax deductions are a matter of legislative grace, statutes providing for them should be narrowly construed against the taxpayer. Deputy v. du Pont, 308 U.S. 488, 493, 60 S.Ct. 363, 84 L.Ed. 416 (1940).

Section 62(a)(4) provides for above-the-line deductions for expenses “attributable to property held for the production of rents or royalties,”

Matter of legislative grace. Narrowly construed against the taxpayer. Wow! Also, IRS Publication 527 Residential Rental Property reads in part-

Vacant while listed for sale.
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. If the property isn’t held out and available for rent while listed for sale, the expenses aren’t deductible rental expenses.

Alrighty then. We really beat that up. There might be wiggle room for mortgage interest as a second home deducted on Schedule A of your individual tax return (Form 1040) along with property taxes.

Ideally, you would keep the rental property occupied while you are wanting to sell. This could be good and bad; it is good if you are selling to another real estate investor, but bad if you are wanting to include families and those who do not want an existing tenant. Also, tenants will not share the same objective or motivation as you. Financial incentives might be required to align everyone’s interests.

Not all is lost on expenses incurred while selling. There might be some expenses directly related to the sale such as real estate commissions, marketing and advertising expenses, repairs or maintenance requested by the buyer, and all the other usual suspects. Some people argue that utilities, such as electricity to keep the rental property in good order for showings, are a selling expense, but this is not definitive.

Deductions When Out of Service to Renovate (Rehab)

This issue is identical to the out of service to sell scenario. IRS Publication 527 Residential Rental Property speaks to vacant rental properties-

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, you can’t deduct any loss of rental income for the period the property is vacant.

However, don’t confuse “hold property for rental purposes” to mean anytime you own a rental property for rental purposes. The key here is holding the property out to rent which is the same as making the rental available to be rented.

Additionally, the IRS in their “Tips on Rental Real Estate Income, Deductions and Recordkeeping“ webpage, they expand slightly by stating-

You can deduct the ordinary and necessary expenses for managing, conserving and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance.

You can deduct the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition.

This is still under the auspice that the rental property is available to rent. As such, WCG CPAs & Advisors recommends keeping the property available for rent as much as possible. If are finishing off the basement, perhaps offer an incentive to the tenants. If the rental property is vacant but still available during the basement renovation, but future tenants are turned off by the prospect of contractors in the home yet the property is otherwise habitable, that might bode well for your tax position.

Renovations or rental property rehabs have some tax deduction opportunities. Please refer to our sections on-

• improvements versus repairs,

• partial asset dispositions,

• qualified improvement property (QIP), and

• cost segregation study.

Once the property is available for rent (goes back into service), then certain expenditures related to the renovation might be deductible as expenses or capitalized with accelerated depreciation.

Converted to Personal Use

This is an easy one to tackle since the last day the rental property is occupied or considered to be available to rent marks the end of your related tax deductions except what is customary for primary or additional homes (mortgage interest, property taxes).

Some additional considerations-

• If you want to use the IRC Section 121 capital gains exclusion, there are some rules and math to determine qualified and non-qualified use. You might also have depreciation recapture as well. Please see our section on selling your rental property.

• If the rental property was acquired through a 1031 like-kind exchange, review the rules regarding the 24 months following the purchase (exchange) before converting the rental property to a primary residence or personal use. We discuss this in our section on 1031 exchanges.