I received the following question through USTaxAid.com.
The reader asks:
Hi, we built a house for the sake of creating a rental. Sole proprietor, claiming as a real estate professional. Question is, are there any limitations of how much can I deduct regarding the land and building costs, and is just the interest deductible with the mortgage? I didn’t see the appropriate deductions for building in the schedule E.
Just to be clear, if you are keeping the property as a long-term rental, you will have passive real estate income or loss from the property. It would be considered a Sole Proprietorship (Schedule C) only if it was a business. Some examples of that would be if you were planning to build it and sell it or if you had it as a short term rental (average stay being less than one week) and provided substantive services such as regular maid service.
Otherwise, this reports on Schedule E and not as a Sole Proprietorship.
While you are building a property out, the costs are capitalized. That means they are not expensed as deductions until the property is put into service.
Once the property is put in service, i.e., you have a Certificate of Occupancy and are advertising to have it rented or actually have it rented, then you can begin to depreciate the costs of building the property. Some of the costs are attributable to land, which is never depreciated, some to the real property which is depreciated over 27.5 or 39 years and some will be personal property depreciated over 5 years to 20 years. You will need to perform a cost segregation study to make the distinction between real property and personal property and assign the valuation to the integral parts of the building.
For now, though, there is likely little deduction that you can take. If it’s related to building out the house, it’s an asset that is later depreciated or partially depreciated.