Depreciation is often a new concept for landlords and unfortunately many landlords, experienced and inexperienced, have mistakes in this area of taxes.
Depreciation can be defined as “a reduction in the value of an asset with the passage of time, due in particular to wear and tear”. Usually (or maybe often or maybe traditionally, I’m not sure the best word to use here since in a way there is a web of rules) assets and improvements are depreciated over time rather than expensed or deducted in one year. The IRS (and the federal and state and some local governments) require it in many cases. In some cases the depreciation can be accelerated faster than the asset’s official lifetime. Or in some cases an asset may be expensed.
An example of depreciation vs. expense – If you buy a $1000 new stove for a rental property and you expense (deduct) it then you subtract $1000 from your rental revenue that year. But if you depreciate it (not using Section 179 or bonus depreciation) then you’ll be deducting that cost over 5 years. There are rules on when you depreciate and when you don’t (there are rules you have to follow to expense that stove rather than depreciate it). Also, rules for when you can choose not to depreciate. And those rules change frequently. Fun stuff.
Please note that depreciation errors are not always corrected by amendment and in nearly all cases the correction does not include just starting depreciation “late”. Often a Change of Accounting Method must be used to correct a depreciation error. The Form 3115 Change of Accounting Method is not a simple form to navigate. Additional instructions and publications must be referenced to use the form properly, including Revenue Procedures which most taxpayers never look at. I highly recommend for the fixing of depreciation errors that a tax professional experienced in these matters be engaged.
If you failed to depreciate (see #1 below), you may be in the position that you can use a Change of Accounting Method to essentially catch up on missed depreciation. This allows you to get a tax benefit that was missed, either immediately or at a later date depending on the details of your tax situation.
Here are 5 mistakes military landlords commonly make with depreciation.
- Not depreciating the rental property. Generally, residential rental real estate is depreciated over 27.5 years. This provides tax savings each year. The tax code has a provision about depreciation recapture which applies if depreciation was taken or if it was allowed. Depreciation recapture is a form of gains and you can look at it as how the IRS gets back the savings you received for depreciating when you sell the property. So you have higher taxes on the sale due to depreciation recapture. Some people don’t want to bother with depreciation, because they don’t want the hassle and they don’t want to deal with depreciation recapture when they sell. But depreciation recapture applies on depreciation allowed in this case (and in most cases). When you don’t depreciate you don’t get the tax savings, but when you sell you get the tax hit from depreciation recapture.
- Depreciating Land. Land is generally viewed as not wearing out, so the cost of land can’t be depreciated. That means you have to separate the cost of the land from the improvements (buildings, structures, etc.) and only depreciate what is depreciable. Land does have a basis, which should be known and tracked.
- Using the wrong basis for depreciation. The number you use to base your depreciation on is called the basis (there are other uses for this term). Some people just use the buy price to determine this basis. Often that is wrong.
- Pub 527 and Pub 946 provide some guidance on how to determine the basis of property. Also Pub 551, Basis of Assets. SOME closing costs can and should be added to the basis. SOME closing costs may be amortized over the life of a loan. SOME closing costs are expensed. Particularly when you convert a property into a rental there may be some costs from purchase that are never deducted in any manner.
- In the case of a converted property (was not an investment property and then converted to rental property) the basis used for depreciation is the lower of the adjusted basis or the Fair Market Value (FMV) when the property is placed in service (when it is available for rent).
- Adjusted basis is basically the original basis plus or minus any changes. Doing an improvement like a new kitchen would generally add to the basis. Some things reduce the basis. Depreciation lowers basis, which is related to depreciation recapture.
- Note that for a building (house, condo, etc) the depreciation basis that should be used could equal the cost basis determined due to the purchase, it could equal an adjusted basis, and in the case of a conversion possibly FMV. Facts and circumstances matter. And. to repeat, it doesn’t include land.
- Using the wrong business percentage. I typically see this one in the first year, when a converted rental property is placed into service. Depreciation schedules require basis, date purchased and/or placed in service, and percentage of business use of the property. The depreciation gets calculated from the date in service and based on the percentage of business use from that point on. So if you placed your rental property in service on July 1, it was a 100% a primary residence from January 1 through June 30 (or at least not in service as a rental), and 100% business use (rented out or available – a rental property) from July 1 through December 31 you should identify it as 100% business use. The software should calculate half a year’s worth of depreciation. If you think since it was rented for half the year, so I’ll put 50% business use, the calculation will be wrong and you will have a much lower depreciation calculated.
- Handling improvements and new assets incorrectly. This gets messy sometimes. And even when it could be easy, you may have options which can complicate reporting and decision making. For this “error” topic I’m speaking about while the property is in service as a rental property.
- Generally -and there are exceptions – if the improvement or asset is permanently affixed to the structure (the residential rental house or building) it gets depreciated at the same rate as the residential rental property – 27.5 years. An HVAC system permanently installed in the house falls into this category. On the other hand carpet is generally viewed as a 5 year depreciation asset. Other flooring options can have varied asset life. Five years and 27.5 years are the most common.
- There are tables that are used to provide some guidance on how long and what methods are used to depreciate based on the asset. Some assets can be depreciated at a rate that is accelerated. Some can be accelerated to be fully depreciated in one year. For some you can elect to expense as long as you meet and follow certain rules. What I’ll call the traditional depreciation method for an electric stove that isn’t permanently installed is over 5 years and is 200DB MACRS. But you often have other options for depreciation methods and options which will permit you to deduct the entire cost of the stove in one tax year.
It may seem like depreciation and handling assets for your taxes is easy in the tax software, but it isn’t so easy from a tax compliance standpoint. Due diligence and/or professional assistance is needed to make sure depreciation is dealt with properly. The publications I mentioned above can be great resources to start with: Pub 527, Pub 946, and Pub 551.
You may have noticed that I use a lot of what I call “disclaimer words” -generally, some, often, may, etc.. This is because each tax situation can be different, so I don’t want you making tax decisions based on this article. The article isn’t intended to provide specific tax advice for your tax situation, but rather to get you thinking. Do your research and due diligence and consult a tax professional when needed.