Hoping to find some answers to this question so I can finally get my tax return done which I have filed an extension for (I know...yikes).  Purchased a condo in a resort beach complex in July '10.  Unit was in bad shape and we spent the rest of the year doing repairs and replacing carpets, countertops, appliances, etc. and finally vacationing. At the time we purchased the unit, our intention was for it to be our second home.  By April of the next year, we were able to purchase ANOTHER condo which was  more what we wanted so we decided to put the 1st unit on the vacation rental market which was a huge success.  By Memorial Day, the 1st unit was booked for all the summer weeks.  No days that year were for personal use. If it wasn't rented, it sat vacant.  When we were visiting the 2nd unit, we usually did the cleanings between guests for the rental unit ourselves  as well as any repairs/maintenance needed.

I am somewhat (an understatement) confused about how to report this rental income and expenses.  Does the cost of the all repairs  and replacements done in 2010 count toward my cost basis for depreciation in 2011? what about the cost of our travel to the property while we were doing all the work (remember at that time, we thought it was to be our vacation home and not to be rented)?  is this considered a 39 year recovery property rather than a 27.5 year property?   can the appliances and furniture expenses be depreciated at a shorter recovery period or do they have to be at the same life as the unit? and ongoing....when we now visit our 2nd unit but we do cleanings and maintenance on the rental unit, are our travel expenses deductible?  what about meals?  

Thanks for any help you can send my way.

Hi Sandy,

The answers are as follows:

1. The repairs you did from July 10 till the end of year will be classified by the IRS as capital expenses. In other words you will need to add them to the basis of the property and recover them through depreciation as all these repairs are part of a general improvement of the property. As the property is a residential building, located within the USA, under MACRS you must depreciate it for 27.5, not for 39 years which is the recovery period for non-residential real property - office for example. Note that the value of your own labor must not be added to the basis. You may add all supplies, carrying charges, materials, etc. Furniture and appliances are depreciated separately under 200% DB method for a period of 5-7 years depending on the type of asset.

2. Your intention was to use the property as a vacation home (personal property). So it is important to properly determine basis on the date the property was first placed in service. It is the date the property was ready and offered for rent, no matter when it was actually rented out for the first time. Your basis for depreciation will be the lesser of your adjusted basis or the FMV of the property.

3. From that date onwards all expenses related to utilities, maintenance, repairs, supplies, taxes, mortgage interest, etc will be deducted currently (unless capital expenses). Same applies to travelling expenses, but only if you travelled away from your "tax home" overnight on business and to the extend they were connected to the production of income (for example, if you worked on the property, went to collect rent, etc). Refer to IRC 162(a)(2) and the regulations hereunder for more information about deductibility. Personal travel is not deductible; same applies to travelling expenses for investment purposes. Meals and Incidental expenses are 50% deductible. Again IRC 162(a)(2).

4. Report the gross rental income on Schedule E of your 1040 tax return (only in case you have rented out the property for more than 15 days during the year). You will be treated as actively participating in the production of income (passive activity loss limitation rules as long as you do some work, maintenance, managing decisions, collection of rent, etc), therefore your passive loss if any will be deductible up to $25k per year. You may use it to offset any other income you might have. The unallowed losses are carried forward to the next tax year and so on.