Depreciation of Rental Property

Depreciation is a deduction to your income that allows you to recover the cost or other basis of property over the expected life of the property. It is an allowance for wear and tear or obsolescence of the property. In reality, the value of real estate property may not decrease at it allowed. So you get benefits by using depreciation against rental income and keep the property value at the same time. Keep in mind that depreciation is mandatory. You must depreciate your property and adjust the basis for gain or loss when you sell the property.

How is depreciation calculated?

Cost Basis-You need to know the Cost Basis which is the cost plus cost of improvements and fees in connection with the purchase such as legal fees, abstract fees, survey charges, and owner’s title.

If you are converting your property from personal use to rental use, your tax basis in the property is calculated differently. Your basis is the lower of these two:

  • Acquisition cost
  • The fair market value at the time of conversion from personal to rental use

When Does Depreciation Start?

It is worthwhile to take a close look at when you can start depreciating. Basically you start depreciating an asset on the date it is placed in service. It is the date that the property is available for rent, not the date rented. Sounds easy but it may not at times. Let us take a look an example:

An investor purchased a rental property. The transaction was closed on March 20. After closing on the property the investor immediately starts work on extensive resotration/remodel of the property. The renovations are not completed until May 15. In anticipation of completing the repair work the investor started listing the property for rent on May 1st. Unfortunately it took a month to find good tenants and they move in July 1st. What date can be used as the In Service date?

Since the rental was initially vacant (so not in service). To be considered In Service there must be some rental activity. Getting a property ready for use does not qualify. Advertising that the property is for rent does qualify though. So the investor could start depreciating the property on June 1st even through the property is vacant and remains so until July 1st.

Same situation as above but the property has existing tenants on the date of transaction. The tenants decided to stay after the investor closes on the deal. The property needs some repairs though and the investor starts what he can while the tenants are living there. In this situation the property would be considered put-in-service on March 20 (the date of closing).

Allocate the Cost basis  among types of Properties

After determining the cost or other tax basis for the rental property as a whole, you must allocate the basis amount among the various types of property because different types of property have different depreciation methods.

Type of Property Method of Depreciation Useful Life in Years
Land Not depreciated N/A
Residential rental real estate (buildings or structures and structural components) SL 27.5
Nonresidential rental real estate SL 39
land improvements (Shrubbery, fences, etc.) 150% DB 15
Furniture or appliances 200%) DB 5

The allocation is generally based on several sources: the county assessor’s, insurance company, mortgage application appraiser.

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