Table of Contents
You recover the cost of income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return.
Three factors determine how much depreciation you can deduct each year: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.
You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.
You may have to use Form 4562 to figure and report your depreciation. See Which Forms To Use in chapter 3. Also see Publication 946.
The following section discusses the information you will need to have about the rental property and the decisions to be made before figuring your depreciation deduction.
You can depreciate your property if it meets all the following requirements.
Certain property cannot be depreciated. This includes land and certain excepted property.
Example.
You built a new house to use as a rental and paid for grading, clearing, seeding, and planting bushes and trees. Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot. If you replace the house, you would have to destroy the bushes and trees right next to it. These bushes and trees are closely associated with the house, so they have a determinable useful life. Therefore, you can depreciate them. Add your other land preparation costs to the basis of your land because they have no determinable life and you cannot depreciate them.
-
Property placed in service and disposed of (or taken out of business use) in the same year.
-
Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements.
You begin to depreciate your rental property when you place it in service for the production of income. You stop depreciating it either when you have fully recovered your cost or other basis, or when you retire it from service, whichever happens first.
You place property in service in a rental activity when it is ready and available for a specific use in that activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.
Example 1.
On November 22 of last year, you purchased a dishwasher for your rental property. The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year. Because the dishwasher was not ready for use last year, it is not considered placed in service until this year.
If the appliance had been installed and ready for use when it was delivered in December of last year, it would have been considered placed in service in December, even if it was not actually used until this year.
Example 2.
On April 6, you purchased a house to use as residential rental property. You made extensive repairs to the house and had it ready for rent on July 5. You began to advertise the house for rent in July and actually rented it beginning September 1. The house is considered placed in service in July when it was ready and available for rent. You can begin to depreciate the house in July.
Example 3.
You moved from your home in July. During August and September you made several repairs to the house. On October 1, you listed the property for rent with a real estate company, which rented it on December 1. The property is considered placed in service on October 1, the date when it was available for rent.
Example.
You bought a home and used it as your personal home several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can begin to claim depreciation in the year you converted it to rental property because at that time its use changed to the production of income.
Continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle (not in use). For example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it is not available for rent.
You must stop depreciating property when the total of your yearly depreciation deductions equals your cost or other basis of your property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it. See Basis of Depreciable Property , later.
You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events.
-
You sell or exchange the property.
-
You convert the property to personal use.
-
You abandon the property.
-
The property is destroyed.
Generally, you must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential rental property placed in service after 1986.
If you placed rental property in service before 1987, you are using one of the following methods.
-
ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987.
-
Straight line or declining balance method over the useful life of property placed in service before 1981.
See MACRS Depreciation , later, for more information.
The basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity.
If you depreciate your property under MACRS, you may also have to reduce your basis by certain deductions and credits with respect to the property.
Basis and adjusted basis are explained in the following discussions.
The basis of property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. Your cost also includes amounts you pay for:
-
Sales tax charged on the purchase (but see Exception later),
-
Freight charges to obtain the property, and
-
Installation and testing charges.
Example.
You buy a house and land for $200,000. The purchase contract does not specify how much of the purchase price is for the house and how much is for the land.
The latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land.
You can allocate 85% ($136,000 ÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷ $160,000) of the purchase price to the land.
Your basis in the house is $170,000 (85% of $200,000) and your basis in the land is $30,000 (15% of $200,000).
You cannot use cost as a basis for property that you received:
-
In return for services you performed;
-
In an exchange for other property;
-
As a gift;
-
From your spouse, or from your former spouse as the result of a divorce; or
-
As an inheritance.
If you received property in one of these ways, see Publication 551 for information on how to figure your basis.
To figure your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service for business or the production of income. The result of these adjustments to the basis is the adjusted basis.
-
The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year.
-
Amounts spent after a casualty to restore the damaged property.
-
The cost of extending utility service lines to the property.
-
Legal fees, such as the cost of defending and perfecting title, or settling zoning issues.
-
Insurance or other payment you receive as the result of a casualty or theft loss.
-
Casualty loss not covered by insurance for which you took a deduction.
-
Amount(s) you receive for granting an easement.
-
Residential energy credits you were allowed before 1986, or after 2005, if you added the cost of the energy items to the basis of your home.
-
Exclusion from income of subsidies for energy conservation measures.
-
Special depreciation allowance claimed on qualified property.
-
Depreciation you deducted, or could have deducted, on your tax returns under the method of depreciation you chose. If you did not deduct enough or deducted too much in any year, see Depreciation under Decreases to Basis in Publication 551.
-
Gain you postponed from the sale of your main home before May 7, 1997, if the replacement home was converted to your rental property.
-
District of Columbia first-time homebuyer credit allowed on the purchase of your main home after August 4, 1997 and before January 1, 2012.
-
Amount of qualified principal residence indebtedness discharged on or after January 1, 2007.
For 2012, your residential rental property may qualify for a special depreciation allowance. This allowance is figured before you figure your regular depreciation deduction. See Publication 946, chapter 3, for details. Also see the Instructions for Form 4562, Line 14.
If you qualify for, but choose not to take, a special depreciation allowance, you must attach a statement to your return. The details of this election are in Publication 946, chapter 3, and the Instructions for Form 4562, Line 14.
Most business and investment property placed in service after 1986 is depreciated using MACRS.
This section explains how to determine which MACRS depreciation system applies to your property. It also discusses other information you need to know before you can figure depreciation under MACRS. This information includes the property's:
-
Recovery class,
-
Applicable recovery period,
-
Convention,
-
Placed-in-service date,
-
Basis for depreciation, and
-
Depreciation method.
MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). You must use GDS unless your are specifically required by law to use ADS or you elect to use ADS.
You cannot use MACRS for certain personal property (such as furniture or appliances) placed in service in your rental property in 2012 if it had been previously placed in service before 1987 when MACRS became effective.
In most cases, personal property is excluded from MACRS if you (or a person related to you) owned or used it in 1986 or if your tenant is a person (or someone related to the person) who owned or used it in 1986. However, the property is not excluded if your 2012 deduction under MACRS (using a half-year convention) is less than the deduction you would have under ACRS. For more information, see What Method Can You Use To Depreciate Your Property? in Publication 946, chapter 1.
If you choose, you can use the ADS method for most property. Under ADS, you use the straight line method of depreciation.
The election of ADS for one item in a class of property generally applies to all property in that class that is placed in service during the tax year of the election. However, the election applies on a property-by-property basis for residential rental property and nonresidential real property.
If you choose to use ADS for your residential rental property, the election must be made in the first year the property is placed in service. Once you make this election, you can never revoke it.
For property placed in service during 2012, you make the election to use ADS by entering the depreciation on Form 4562, Part III, Section C, line 20c.
Each item of property that can be depreciated under MACRS is assigned to a property class, determined by its class life. The property class generally determines the depreciation method, recovery period, and convention.
The property classes under GDS are:
-
3-year property,
-
5-year property,
-
7-year property,
-
10-year property,
-
15-year property,
-
20-year property,
-
Nonresidential real property, and
-
Residential rental property.
Under MACRS, property that you placed in service during 2012 in your rental activities generally falls into one of the following classes.
-
5-year property. This class includes computers and peripheral equipment, office machinery (typewriters, calculators, copiers, etc.), automobiles, and light trucks.
This class also includes appliances, carpeting, furniture, etc., used in a residential rental real estate activity.
Depreciation on automobiles, other property used for transportation, computers and related peripheral equipment, and property of a type generally used for entertainment, recreation, or amusement is limited. See chapter 5 of Publication 946.
-
7-year property. This class includes office furniture and equipment (desks, file cabinets, etc.). This class also includes any property that does not have a class life and that has not been designated by law as being in any other class.
-
15-year property. This class includes roads, fences, and shrubbery (if depreciable).
-
Residential rental property. This class includes any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. It does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part you live in.
The recovery period of property is the number of years over which you recover its cost or other basis. The recovery periods are generally longer under ADS than GDS.
The recovery period of property depends on its property class. Under GDS, the recovery period of an asset is generally the same as its property class.
Class lives and recovery periods for most assets are listed in Appendix B of Publication 946. See Table 2-1 for recovery periods of property commonly used in residential rental activities.
-
The date the addition or improvement is placed in service, or
-
The date the property to which the addition or improvement was made is placed in service.
Example.
You own a residential rental house that you have been renting since 1986 and depreciating under ACRS. You built an addition onto the house and placed it in service in 2012. You must use MACRS for the addition. Under GDS, the addition is depreciated as residential rental property over 27.5 years.
| MACRS Recovery Period | |||
| Type of Property | General Depreciation System |
Alternative Depreciation System |
|
| Computers and their peripheral equipment | 5 years | 5 years | |
| Office machinery, such as: Typewriters Calculators Copiers |
5 years | 6 years | |
| Automobiles | 5 years | 5 years | |
| Light trucks | 5 years | 5 years | |
| Appliances, such as: Stoves Refrigerators |
5 years | 9 years | |
| Carpets | 5 years | 9 years | |
| Furniture used in rental property | 5 years | 9 years | |
| Office furniture and equipment, such as: Desks Files |
7 years | 10 years | |
| Any property that does not have a class life and that has not been designated by law as being in any other class |
7 years | 12 years | |
| Roads | 15 years | 20 years | |
| Shrubbery | 15 years | 20 years | |
| Fences | 15 years | 20 years | |
| Residential rental property (buildings or structures) and structural components such as furnaces, waterpipes, venting, etc. |
27.5 years | 40 years | |
| Additions and improvements, such as a new roof | The same recovery period as that of the property to which the addition or improvement is made, determined as if the property were placed in service at the same time as the addition or improvement. | ||
A convention is a method established under MACRS to set the beginning and end of the recovery period. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.
Example.
During the tax year, Tom Martin purchased the following items to use in his rental property. He elects not to claim the special depreciation allowance discussed earlier.
-
A dishwasher for $400 that he placed in service in January.
-
Used furniture for $100 that he placed in service in September.
-
A refrigerator for $800 that he placed in service in October.
Tom uses the calendar year as his tax year. The total basis of all property placed in service that year is $1,300. The $800 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $520 (40% × $1,300). Tom must use the mid-quarter convention instead of the half-year convention for all three items.
You can figure your MACRS depreciation deduction in one of two ways. The deduction is substantially the same both ways. You can either:
-
Actually compute the deduction using the depreciation method and convention that apply over the recovery period of the property, or
-
Use the percentage from the MACRS percentage tables.
In this publication we will use the percentage tables. For instructions on how to compute the deduction, see chapter 4 of Publication 946.
You can use the percentages in Table 2-2, earlier, to compute annual depreciation under MACRS. The tables show the percentages for the first few years or until the change to the straight line method is made. See Appendix A of Publication 946 for complete tables. The percentages in Tables 2-2a, 2-2b, and 2-2c make the change from declining balance to straight line in the year that straight line will give a larger deduction.
If you elect to use the straight line method for 5-, 7-, or 15-year property, or the 150% declining balance method for 5- or 7-year property, use the tables in Appendix A of Publication 946.
-
Depreciation allowed or allowable, or
-
An addition or improvement that is depreciated as a separate item of property.
-
Any amortization,
-
Any section 179 deduction, and
-
Any special depreciation allowance.
){kind=link}
Example 1.
You purchased a stove and refrigerator and placed them in service in June. Your basis in the stove is $600 and your basis in the refrigerator is $1,000. Both are 5-year property. Using the half-year convention column in Table 2-2a, the depreciation percentage for Year 1 is 20%. For that year your depreciation deduction is $120 ($600 × .20) for the stove and $200 ($1,000 × .20) for the refrigerator.
For Year 2, the depreciation percentage is 32%. That year's depreciation deduction will be $192 ($600 × .32) for the stove and $320 ($1,000 × .32) for the refrigerator.
Example 2.
Assume the same facts as in Example 1, except you buy the refrigerator in October instead of June. Since the refrigerator was placed in service in the last 3 months of the tax year, and its basis ($1,000) is more than 40% of the total basis of all property placed in service during the year ($1,600 × .40 = $640), you are required to use the mid-quarter convention to figure depreciation on both the stove and refrigerator.
Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 2-2a and find the depreciation percentage for Year 1 is 5%. Your depreciation deduction for the refrigerator is $50 ($1,000 x .05).
Because you placed the stove in service in June, you use the second quarter column of Table 2-2a and find the depreciation percentage for Year 1 is 25%. For that year, your depreciation deduction for the stove is $150 ($600 x .25).
Example.
You purchased a single family rental house for $185,000 and placed it in service on February 8. The sales contract showed that the building cost $160,000 and the land cost $25,000. Your basis for depreciation is its original cost, $160,000. This is the first year of service for your residential rental property and you decide to use GDS which has a recovery period of 27.5 years. Using Table 2-2d, you find that the percentage for property placed in service in February of Year 1 is 3.182%. That year's depreciation deduction is $5,091 ($160,000 x .03182).
Table 2-1, earlier, shows the ADS recovery periods for property used in rental activities.
See Appendix B in Publication 946 for other property. If your property is not listed in Appendix B, it is considered to have no class life. Under ADS, personal property with no class life is depreciated using a recovery period of 12 years.
Use the mid-month convention for residential rental property and nonresidential real property. For all other property, use the half-year or mid-quarter convention, as appropriate.
See Publication 946 for ADS depreciation tables.
You should claim the correct amount of depreciation each tax year. If you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. For more information, see Depreciation under Decreases to Basis in Publication 551.
If you deducted an incorrect amount of depreciation for property in any year, you may be able to make a correction by filing Form 1040X, Amended U.S. Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation.
-
You claimed the incorrect amount because of a mathematical error made in any year.
-
You claimed the incorrect amount because of a posting error made in any year.
-
You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003.
-
You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003.
-
3 years from the date you filed your original return for the year in which you did not deduct the correct amount. A return filed before an unextended due date is considered filed on that due date.
-
2 years from the time you paid your tax for that year.
chapter 1.
| More Online Publications |