Rental Property Acquisition Costs
By Jason Watson, CPA
Posted Saturday, August 3, 2024
The question comes up often- Can I deduct my expenses for travel including lodging and meals for the purpose of acquiring rentals and real estate investments? The answer is Yes, eventually. Huh?
While we are getting ahead of ourselves, let’s look at acquisition time first while considering material participation. While we will address material participation in a later chapter, and how time is used to support the claim, the theory behind acquisition time helps set the stage for all things acquisition including acquisition costs.
Acquisition Time
There are all kinds of chatter with various tax court cases and IRS regulations about what time counts and what time doesn’t when it comes to acquisition and start-up activities for your rental property. Let’s review Section 469(c)(7) of the Internal Revenue Code again for fun-
For purposes of this paragraph, the term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Full-on disclaimer here- several resources out there are all over the map and most provide caveats stating what exactly counts as acquisition time and what does not count is unclear. Lovely, right? We tend to swim in gray waters all the time with taxes… add acquisition time to the list. You should not be afraid of an audit. You should not be afraid of losing an audit. You should be afraid, however, of having an unreasonable tax position.
Let’s run through a scenario-
- You spend 10 hours looking at Zillow and crunching numbers. Those hours are considered investor hours, and therefore do not count (yet).
- You find a rental property, and travel to the location for inspection. You spend time reviewing the inspection reports and contracts and whatnot. This time is still investor time.
- You close on the deal, and boom, investor hours convert to acquisition hours. The specific hours spent on Zillow associated with the property acquisition suddenly count towards material participation. We take a deeper look at travel time in our material participation section.
To be certain, the above example is not detailed in an IRS publication or memo or revenue procedure. This is simply a plain reading of IRC Section 469(c)(7) mixed with some common sense. Let’s take a step back for a minute. The material participation rules (which we will discuss later) can be viewed as a quasi-safe harbor or bright line, right? With any safe harbor, they are designed to replace an arduous facts and circumstances based argument, and usually in the interest of judicial efficiency. Think of the hobby loss rule- you can either prove a profit motive with your facts and circumstances (and stellar recordkeeping), or you can have profits 3 out of 5 years. Simple, right?
Similarly, rental property material participation rules are trying to determine one thing- is this a passive activity or not? Is this rental property being operated like a business with a profit motive? Is it a rental investment or a rental business?
The Internal Revenue Code is trying to say that if you meet one of the material participation rules, then the activity is automagically deemed to be “business-like.” While so many people warn against the “facts and circumstances” argument, we must remind ourselves of the underpinnings of determining material participation- at the risk of repeating ourselves, is this some side-gig hobby-esque passive whatever whatever, or is this a real business with a real vision and commercial substance?
What’s a trade or business as referenced in IRC Section 469(c)(7)? Good question! It is one of the squishiest terms in the tax code. Here is a blurb from the IRS regarding non-profit entities-
The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services.
Note the highlighted part “performing services.” This also goes to the underpinnings of the material participation concept. Are you performing services for the activity enough to be considered materially participating and therefore operating a trade or business?
Sorry for the digression, but keep in mind the philosophy of the tax code when considering acquisition time and material participation. Armed with that knowledge, let’s turn to acquisition costs.
Acquisition Costs
Travel expenses including lodging and meals are not considered rental deductions when searching for new rental properties or real estate investments. However, they are added to the basis of the rental property as acquisition costs, and depreciated accordingly, once you close on the purchase under two conditions-
- You have a home office that you use regularly and exclusively (which we will discuss in more detail later), or
- You travel outside your tax home to another market or location.
Now we need to define “tax home.” According to IRS Topic 511 Business Travel Expenses–
Travel expenses are the ordinary and necessary expenses of traveling away from home for your business, profession, or job. You can’t deduct expenses that are lavish or extravagant, or that are for personal purposes.
You’re traveling away from home if your duties require you to be away from the general area of your tax home for a period substantially longer than an ordinary day’s work, and you need to get sleep or rest to meet the demands of your work while away.
Generally, your tax home is the entire city or general area where your main place of business or work is located, regardless of where you maintain your family home. For example, you live with your family in Chicago but work in Milwaukee where you stay in a hotel and eat in restaurants. You return to Chicago every weekend. You may not deduct any of your travel, meals or lodging in Milwaukee because that’s your tax home. Your travel on weekends to your family home in Chicago isn’t for your work, so these expenses are also not deductible. If you regularly work in more than one place, your tax home is the general area where your main place of business or work is located.
Ok. Neat. Let’s say you cannot justify or support a home office claim, and you need to rely on “travel outside your tax home” threshold. How big is that geographical location? Is the rental property down the street outside my tax home? Unlikely. How about the one in a neighboring town? Perhaps.
Here is the IRS excerpt again-
Generally, your tax home is the entire city or general area where your main place of business or work is located.
This is certainly ambiguous, right? To make matters worse, and in the context of a home office, there is a derived (some would say contrived) 50-mile radius rule. It is derived from IRC Section 162(h) which defines the local area for state legislators as 50 miles. The federal government defines metropolitan area for IRS employees as 50 miles from an IRS office as detailed in the Internal Revenue Manual 6.550.1.1.7 (revised December 2009). There are other references to 50 miles, so it is a good rule of thumb to use.
To recap, travel expenses including lodging and meals, may be added to the cost basis of your rental property as acquisition costs when you have a valid home office or when the rental is outside your tax home.
How do multiple trips work? Two scenarios that are equal in tax treatment- first, you travel to Miami four different times looking at various rental properties each time, and you eventually close on a nice condo. Second, you travel to Miami four different times for the same rental property to a) find it, b) be present for inspections, c) sign-off on a seller repair and contingency and d) final walk-through and closing.
The costs associated with the four trips to Miami would be added to the purchased rental property’s basis in either situation. It gets trickier for the second rental that you purchase in Miami.
What if you travel to Miami, Hilton Head and Key West, and then finally find and close on a real estate investment in Miami. Do the Hilton Head and Key West travel expenses get added to the Miami rental property? Short-answer, No because they were different geographical locations.
Keep in mind that with any expense, it must be ordinary and necessary, and not considered lavish or extravagant. We will drive these terms home in another chapter.
Closing Costs
Loan costs are commonly forgotten on rental property setups. Approach this by asking yourself what costs would I have incurred if the purchase was made with cash, and without borrowing. Those costs typically include abstract fees, charges for installing utility services, legal and recording fees, surveys, transfer taxes, title insurance, and any amounts the seller owes that you agree to pay (such as back taxes or interest, recording or mortgage fees, sales commissions and charges for improvements or repairs). This list is straight from the IRS website.
The amounts above are considered acquisition costs, and are added to the basis of the rental property. Easy.
What about loan costs? The costs beyond a cash deal? Unlike your primary residence, where you can only deduct qualified points and interest, you can amortize all costs associated with obtaining a new mortgage for your rental property over the life of the loan (usually 30 years). Common loan-related expenses include points, loan origination and loan assumption fees, mortgage insurance premiums, application fees, credit report fees and appraisal fees (if required by the lender).
Quick example. $3,000 in loan-related costs amortized over a 30-year loan would be $100 per year (and therefore deducted). Amortization is similar to depreciation but relates mostly to intangible assets such as goodwill, patents, copyrights, and loan costs.
Be careful of impound and prepaids on the closing disclosure or settlement statement. If you are asked to impound 6 months of mortgage interest or property taxes, these are not loan costs.
Here are some more acquisition and closing costs that are commonly overlooked-
- Application fees, and similar expenses.
- Property appraisals and inspections including architectural, engineering, environmental, and geological services.
- Legal and accounting fees including tax advice to review offers, purchase or sales agreements.
- Costs to obtain regulatory approval or secure permits (think short-term rental permits).
- Cost of services provided by a qualified intermediary in a like-kind exchange.
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