Deducting Your Real Estate Start-Up Costs
Treatment of start-up costs per U.S. GAAP and the Internal Revenue Service (IRS)
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Are you actively investing in Real Estate? Then you likely are setting up a business, or have set up one recently. Even if you are starting off by buying your first rental property, you are starting a business, and your bank account certainly knows there are costs involved in setting up your real estate investment business.
Many of your start-up costs are incurred before your business is operational, and can include a variety of expenses from investigating the viability of the business to legal costs to set up the business. In real estate, you may even start up “multiple” businesses to silo your properties as you acquire them, so the guidance below becomes even more important to remember.
All costs related to setting up the business are categorized as business start-up costs and treated the same way under U.S. GAAP (Generally Accepted Accounting Principles). However, for tax purposes, the treatment of these costs is more nuanced.
Confusion is common on the accounting treatment of these costs given the differences between U.S. GAAP and the IRS. The accounting treatment per your books should follow U.S. GAAP and you will need to have a book to tax adjustment on Schedule M-1 at the time of tax filing.
The following is a brief description of the differences between the treatments.
Book Treatment per U.S. GAAP
Start-up costs are expenses related to activities that prepare a business to become operational. Per U.S. GAAP (ASC 720–15–20), these start-up activities are broadly defined as one-time activities related to any of the following:
Opening a new facility;
Introducing a new product or service;
Conducting business in a new territory;
Conducting business with an entirely new class of customers;
Initiating a new process in an existing facility; and
Commencing some new operation.
Per ASC 720–15–25, the costs of start-up activities (defined above) including organization costs, shall be expensed as incurred.
Tax Treatment per the IRS
The IRS has different definitions of start-up costs and organizational costs (unlike U.S. GAAP). You have to list them out separately on your tax returns.
Start-up costs include any amounts paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Start-up costs include amounts paid for the following:
An analysis or survey of potential markets, products, labor supply, partners, etc.
Advertisements for the opening of the business.
Salaries and wages for employees who are being trained and their instructors.
Travel and other necessary costs for securing prospective properties, service providers, suppliers, or customers.
Salaries and fees for executives and consultants, or for similar professional services.
Cannot include interest, taxes, or research and experimental costs.
Organizational costs include costs of creating a corporation or partnership. Organizational costs include amounts paid for the following:
Legal fees for drafting a partnership agreement or corporate charter.
Accounting services necessary to set up the company.
State filing fees (incorporation fees).
Cost of organizational meetings.
Cost of temporary directors.
Per the IRS, start-up costs and organizational costs are treated as capital expenditures. However, you can elect to expense/deduct up to $5,000 of business start-up costs and $5,000 of organizational costs incurred after October 22, 2004. The $5,000 expense/deduction amount is phased out dollar for dollar by the excess amount over $50,000 in start-up or organizational costs. The remaining cost must be amortized over 180 months (15 years).
Talk to your CPA about how to categorize your expenses correctly and even when to spend for certain expenses to lower your tax impact.