“According to the IRS publications if we do not show a profit in 2 out of 5 years I believe the IRS can demand we treat this property as a rental not for profit. By doing that we would not be able to offset our wages with the rental loss.”--->Correct; in that case, you can’t use a loss from the rental property to offset other ordinary income. You can deduct your expenses up to the amount of your income on your return. An individual can take the deductions ONLY by itemizing the deductions on 1040 Sch A. However, personal( mortgage interest expenses, property taxes or etc.) and investment business related deductions(utilities, repairs, or insurance or etc.) are allowed to be deducted in full.Your investment business deductions decreasing the basis of the property are allowed only to the extent of the gross income from the activity exceeding the deductions you take under the personal and investment business related deductions.
“ I also read if the IRS were to make us treat this as a not for profit rental they could go back and make any losses in the past 5 years retroactive. “---> As long as you do not have profits for 3 years, your deduction limit can be applied retroactively to any year with a loss during the five year term.
“I guess the short question is if we are expecting losses in the coming years should we just start from day 1 and file this as a rental not for profit? “---->I guess so. I guess you can(MAY) file Form 5213 later. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. If you are engaged in an activity with an intent to make a profit, and if you are prepared to argue with the IRS in the event that they challenge you, then the law does not prohibit you from claiming deductions for losses every year without any restriction on the number of years such losses can be deducted. You do not have to forgo your loss deductions even if you don’t have a profit in three of every five years. But you do have to be able to convince the IRS or a judge that your primary purpose for the activity is to make a profit. That profit doesn’t have to occur right away. Some businesses take many years to reach the point where they are able to show a profit. To demonstrate that your activity is profit motivated, you need to demonstrate that the activity is being operated in a business like manner and that you have a reasonable business plan that will lead to economic success. At a minimum, you should have a name for the business, some stationary, a separate bank account, separate books and records, your home that is used only for rental investment business activity and some records to show that you are spending some time working on this activity on a regular basis. A daily log or journal would be a substantial help in this regard.
“Second, in determining our basis in the property for depreciation can we include the points and fees from the original 2003 loan?”---->I guess no; the basis for depreciation of your townhome converted to rental use is the lesser of: the FMV of the property on the date you changed it to rental use, or your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis. For other increases and decreases to basis. The term "points" is used to describe certain charges paid to obtain a home mortgage. Your points paid to buy the townhome are prepaid interest, and may be deductible as home mortgage interest, if you itemize deductions on Form 1040, Schedule A. If you can deduct all of the interest on your mortgages, you may be able to deduct all of the points paid on the mortgage. You can EVEN deduct the points in full in the year they are paid; points and fees are NOT added to the basis of the property.
“ My assumption is no since we deducted those on our 2003 taxes. “--->Corret.
Please visit the IRS website here; Publication 535 (2009), Business Expenses