Depreciation of Rental Property

A taxpayer recovers the cost of income-producing property (such as rental property) through depreciation deductions. By deducting some of the cost of the property each year on a tax return, a taxpayer depreciates property. Three factors determine how much depreciation a taxpayer may deduct in a specific tax year. First, the taxpayer’s basis in a property. Second, the recovery period of the income-producing property. Finally, a taxpayer’s depreciation method. A taxpayer must take all three of these factors into consideration to correctly calculate a depreciation deduction.

A taxpayer may deduct depreciation only on the part of a property used for rental purposes; because depreciation deductions relate to income-producing property. However, a taxpayer landlord will not qualify for a section 179 deduction meaning he or she cannot recover part or all the cost qualifying business-use property in the year the property is placed in service.

Accelerated depreciation allows a taxpayer to deduct more depreciation sooner than he/she could deduct using a straight-line method. However, a taxpayer who uses accelerated depreciation may be subject to the Alternative Minimum Tax, or AMT.

Depreciating Rental Property

A taxpayer may depreciate property if it meets each of four requirements. First, a taxpayer must own property. For the purposes, a taxpayer is considered owner of property even if the property is subject to a debt (such as a mortgage). Second, a taxpayer must use property in a business or income-producing activity to depreciate the property. For the purposes if this standard, residential rental activities are considered income-producing activities. Third, property must have a determinable useful life to qualify for depreciation. Finally, property must be expected to last for more than one year to qualify to be depreciated.

A property is considered placed in service when it is “ready and available” for specific rental activity. Even if a taxpayer does not actually make use of the property, the property will be considered placed in service when it is ready to rent. In cases where a taxpayer converts a property from personal use to rental use, the property will be considered placed in service on the date of the conversion.

If rental property becomes idle after being placed in service, a taxpayer may continue to claim a depreciation deduction. A taxpayer stops depreciating rental property after the first of two events: Either the taxpayer fully recovers the cost (or other basis) in the property; or the property is retired from service.

Depreciation Methods and the Basis of Depreciable Property

A taxpayer must depreciate the property using the Modified Accelerated Cost Recovery System(MACRS), the straight-line, or declining balance methods. the depreciation basis of residential rental property is the property’s adjusted basis on the date it was placed in service for rental activities. The adjusted basis on the date that a property was placed in service will be equal to the cost (or other basis) of the property when the taxpayer acquired it, adjusted for certain occurrences that took place before the property was placed in service.

If a taxpayer uses a property for personal purposes before converting the property to rental, the property’s basis for depreciation will be the smaller of the property’s adjusted basis, or the fair market value of the property on the date that the property was converted to rental use.

When a taxpayer purchases property, the basis is generally the cost paid by the taxpayer. The cost of a property includes: Amounts paid in cash, debt obligation, other property, or services, sales tax charged on the purchase, freight charges incurred to obtain the property, and installation and testing charges. Certain other expenses and fees incurred by a taxpayer when buying real property are also part of the taxpayer’s cost basis in the property. For example, if a taxpayer buys property and agrees to pay real estate taxes that were owed by the seller, the taxes paid by the purchaser are treated as part of the purchaser’s basis in the property, if the seller does not reimburse the purchaser for the tax payment. Other settlement fees and closing cost such as abstract fees, charges for installing utilities services, legal fees, recording fees, surveys, transfer taxes, title insurance, and any other amounts of money that the seller owes that the purchaser agrees to pay (such as sales commissions, mortgage fees, and repair costs) are also part of taxpayer’s basis in real property.

Adjustment to Basis

When a taxpayer purchases a property to use in rental activities, the initial basis in the property is the cost of the property. Certain events increase the basis of property. The cost of any additions or improvements made before the property was placed in service as a rental unit if expenses are incurred to restore damage to the property after a casualty, the cost of extending utility service lines to a property, and legal fees (for example, legal costs related to settling zoning issues)

Certain events decrease a property’s basis. These events include all of the following: Insurance payments (or other payments) received as the result of casualty or theft, casualty losses that were not covered by insurance for which a taxpayer took a deduction, amounts received by a taxpayer for granting an easement, certain residential energy credits allowed before 1986 or after 2005 (as long as the taxpayer added the cost of the energy items to the basis of the home); the exclusion from income of certain subsidies for energy conservation measures; the special depreciation allowance claimed on qualified property, and depreciation that the taxpayer deducted (or could have deducted) on the  return under the taxpayer’s method of depreciation.

For a taxpayer whose rental property was previously used as main home, basis must also be decreased by three additional amounts. First, the amount of any gain postponed from the sale the main home before May 7, 1997, if the replacement home was converted to a rental property. Second, a taxpayer must reduce the basis by the amount of first time homebuyer credit in the state where it is applicable; if the credit was taken between August 4, 1997 and January 1, 2012. Finally, a taxpayer whose rental property was previously used as the main home must also reduce basis by the amount of qualified principal residence indebtedness that was discharged after January 1, 2007.