How to determine cost basis for rental property depreciation

When you rent out a house or condo, taxes can be a headache.

Consider this scenario:

After buying a condo and living in it for several years, Sue meets Steve, marries him and moves into his house. Because the rental market in their area is improving, they decide that instead of selling Sue's condo, they could make some money by holding on to it and renting it out. But as first-time landlords, they don't know whether they need to report the rent they receive on their tax return and, if so, whether any of the money they spent to get the condo ready to rent is deductible.

Does this story sound familiar? If so, you're not alone. Taxpayers in similar circumstances find themselves asking these questions:

Is rental income taxable?

Yes, rental income is taxable, but that doesn't mean everything you collect from your tenants is taxable. You're allowed to reduce your rental income by subtracting expenses that you incur to get your property ready to rent, and then to maintain it as a rental.

• You report rental income and expenses on Schedule E, Supplemental Income and Loss.
• Schedule E is then filed with your Form 1040.

When do I owe taxes on rental income?

In general, you must report all income on the return for the year you actually receive it , even though it may be credited to your tenant for a different year.

• If you receive rent for January 2023 in December 2022, for example, report the rent as income on your 2022 tax return.
• If you receive a deposit for first and last month's rent, it's taxed as rental income in the year it's received.
• If you receive goods or services from your tenant in exchange for rent, you must report the value of the goods or services as rental income on your return for the year in which you receive them.
• You must also report income that you have received constructively. This means the funds are available to you even if you haven't taken possession of them. For example, if your renters place their January 2022 checks in your mailbox late in December of 2022, you cannot avoid reporting the rent as 2022 income by simply leaving the checks in your mailbox until January 2023.

Are security deposits taxable?

Security deposits are not included in income when you receive them if you plan to return them to your tenants at the end of the lease. In contrast, deposits for the last month's rent are taxable when you receive them, because they are really rents paid in advance.

What if I pocket some of the security deposit?

If you eventually keep part or all of the security deposit because the tenant does not live up to the terms of the lease, you must include that amount as income on your tax return for the year in which the lease terminates. Of course, if you withhold the security deposit to cover damages caused by the tenant, the cost of repairing such damage will be deductible, and offset the income from the forfeited security deposit.

So, you should keep track of the security deposits from year to year. This record-keeping isn't difficult if you only own one rental property, but as the number of rentals you own increases, so does the paperwork.

If I rent out my vacation home, can I still use it myself?

Only for a very limited amount of time each year if you want the chance to fully deduct losses on your rental property. To be treated as a rental property for tax-loss purposes, your personal use of the place can't exceed 14 days or 10% of the days the unit is rented during the year, whichever is greater. While 10% may sound like a lot, it really isn't when you figure that a seasonal rental may only be in demand for two or three months each year.

• If you violate the 14-day/10% rule, you can still deduct expenses associated with the rental, but only to the extent of your rental income.
• In other words, the property can't produce a net loss that will offset the income from other sources.

What can I deduct?

Costs you incur to place the property in service, manage it and maintain it generally are deductible. Even if your rental property is temporarily vacant, the expenses are still deductible while the property is vacant and held out for rent.

Deductible expenses include, but are not limited to:

• Advertising
• Cleaning and maintenance
• Commissions
• Depreciation
• Homeowner association dues and condo fees
• Insurance premiums
• Interest expense
• Local property taxes
• Management fees
• Pest control
• Professional fees
• Rental of equipment
• Rents you paid to others
• Repairs
• Supplies
• Trash removal fees
• Travel expenses
• Utilities
• Yard maintenance

All expenses you deduct must be ordinary and necessary, and not extravagant. You can deduct the cost of travel to your rental property, if the primary purpose of the trip is to check on the property or perform tasks related to renting the property. If you mix business with pleasure, though, you're required to allocate the travel costs between deductible business expenses and nondeductible personal costs. Be careful not to cheat yourself on the breakdown.

Consider this example:

John, who lives in North Carolina and loves to ski, owns a rental condo in Park City, Utah, which he visits each January to get the place ready for that season's tenants. His travel expenses are deductible if, for example, the primary purpose of his trip is to clean and paint the unit. Let's say that during a five-day visit to the condo, John spends three days cleaning and painting and two days skiing.

Some advisors would say he gets to deduct 60% of his travel costs, since 60% of the time was spent on the business of tending to his rental unit. But following that advice would be a costly mistake.

• Since the primary purpose of the trip is business, the full cost of transportation to and from Park City is deductible. It's the costs while there that need to be allocated between business and personal expenses.
• 60% of the cost of a rental car would be deductible, for example, plus the cost of meals during the three business days. (Another tax law restriction limits your deduction for business meals to 50% of the cost.)

Now, if John spent three days skiing and two days working on the condo, none of his travel expenses would be deductible, although the direct costs of working on the condo (the cost of paint and cleaning supplies, etc.) would be deductible rental expenses.

To deduct any expense, you must be able to document the write-off. So hold on to all receipts, cancelled checks, and bank statements.

To understand more about tax deductions, visit our Self-Employed Tax Deduction Calculator for Real Estate Agents.

Can I deduct improvements and repairs?

Ah, there's a big difference between improvements and repairs. The cost of property improvements  generally must be capitalized and depreciated over several years (by following IRS depreciation tables) rather than deducted in the year paid. By contrast, the cost of repairs can be written off in the year you pay them.

Improvements are actions that materially add to the value of the property or substantially prolong its life. Examples include:

• Additions to the structure
• Adding a swimming pool
• Installing a water filtration system
• Modernizing a kitchen
• Installing insulation

Repairs, on the other hand, just keep the property in good operating condition. Examples of repairs:

• Painting
• Repairing appliances
• Fixing leaks
• Replacing broken windows or doors

For more information see IRS Topic 414: Rental Income and Expenses.

How do I calculate depreciation?

Depreciation is a deduction taken over several years. You generally depreciate the cost of business property that has a useful life of more than a year, but gradually wears out, or loses its value due to wear and tear, weather damage, etc. To figure out the depreciation on your rental property:

1. Determine your cost or other tax basis for the property.
2. Allocate that cost to the different types of property included in your rental (such as land, buildings, so on).
3. Calculate depreciation for each property type based on the methods, rates and useful lives specified by the IRS.

1. Determine your cost basis

Your cost basis in the property is generally the amount that you paid for the property (your acquisition cost plus any expenses), including any money you borrowed to buy the place.

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:

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

If the property was given to you or if you inherited it, or if you traded another property for the current property, there are special rules for determining your tax basis in your rental property.

• If you were given the property, for example, your basis is generally the same as the basis of the generous soul who gave it to you.
• If you inherited the property, your basis is generally the property's value on the day the previous owner died. (Special rules apply to property inherited from people who died in 2010.)
• Consult IRS Publication 551: Basis of Assets for more information about these situations.

2. Allocate the cost by type of property

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 you're renting. When we speak of types of property, we refer to certain components of your rental, such as the land, the building itself, any furniture or appliances you provide with the rental, etc.

• If your rental is a condo or other property that shares property within a community, you're deemed to own a portion of that property.
• A portion of the land and a portion of the purchase price must be allocated to the land on which the building sits.

Why this effort to divide your tax basis between property types? They are each depreciated using different rules and different lives.

3. Calculate the depreciation for each type of property

Here are the most common divisions of tax basis for a rental property, followed by explanations of the different methods of depreciation that generally apply:

Straight-line depreciation

In straight-line depreciation, the cost basis is spread evenly over the tax life of the property. For example:

A residential rental building with a cost basis of $150,000 would generate depreciation of $5,455 per year ($150,000 / 27.5 years).

• In the year that the rental is first placed in service (rented), your deduction is prorated based on the number of months that the property is rented or held out for rent, with 1/2 month for the first month.
• If the building in the example above is placed in service in August, you can take a deduction for 4½ months' worth of depreciation, amounting to $2,046 ($5,455 x 4.5/12).

Declining balance depreciation

This kind of depreciation is calculated by multiplying the rate, 150% or 200%, by the straight-line depreciation calculated based on the adjusted balance of the property at the start of the year over the remaining life of the property. To make matters somewhat easier, the IRS and others publish tables of percentages that can be applied to the original cost to determine yearly depreciation.

For instance, here's the 200% declining balance table for five-year property:

Example:

The 200% declining balance depreciation on $2,400 worth of furniture used in a rental would be $461 in Year 3 ($2,400 x 19.20%).

Bonus Depreciation: Bonus depreciation has been changed for qualified assets acquired and placed in service after September 27, 2017. The old rules of 50% bonus depreciation still apply for qualified assets acquired before September 28, 2017. These assets had to be purchased new, not used. The new rules allow for 100% bonus "expensing" of assets that are new or used.

The percentage of bonus depreciation phases down in

• 2023 to 80%,
• 2024 to 60%,
• 2025 to 40%, and
• 2026 to 20%.
• After 2026 there is no further bonus depreciation.

This bonus "expensing" should not be confused with expensing under Code Section 179 which has entirely separate rules.

The 100% expensing is also available for certain productions (qualified film, television, and live staged performances) and certain fruit or nuts planted or grafted after September 27, 2017.

50% bonus first year depreciation can be elected over the 100% expensing for the first tax year ending after September 27, 2017.

Tables for all types of properties can be found in IRS Publication 946: How to Depreciate Property. For general information on depreciation of rentals, see IRS Publication 527: Residential Rental Property.

How do I report a rental activity on my tax return?

As an individual, you report the income and deductions for rental properties on Schedule E: Supplemental Income and Loss. The total income or loss computed on Schedule E carries to page 1 of your Form 1040.

Report the depreciation of rentals on Form 4562: Depreciation and Amortization.

What are passive activities and how do they affect me?

As a general rule, rental properties are, by definition, passive activities and are subject to the passive activity loss rules. These rules are quite complex. In general, the passive activity rules limit your ability to offset other types of income with net passive losses.

But the good news is there is an exception: If you actively participate in a rental real estate activity, you can deduct up to $25,000 of your rental loss even though it’s passive. To actively participate means that you:

• own at least 10% of the property, and
• make major management decisions, such as approving new tenants, setting rental terms, approving improvements and so forth. (No, you don't have to mow the lawn or answer middle-of-the-night phone calls from tenants about a backed-up toilet.)

But this exception phases out as your income rises.

• If you have modified Adjusted Gross Income over $100,000, the $25,000 rental real estate exception decreases by $0.50 for every dollar over $100,000.
• The exception is completely phased out when your modified adjusted gross income reaches $150,000.

Example:

Phil and Mary have modified Adjusted Gross Income of $90,000 and a rental loss for the year of $21,000. They actively participated in the rental. Since their modified Adjusted Gross Income is below the  $100,000 phase-out threshold, their entire rental loss is deductible even though it is a passive loss.

• If their loss had risen to $28,000, they would have been limited to a deductible loss of $25,000 for the  year.
• The nondeductible balance of $3,000 is a passive loss that is carried over to future years until the passive loss tax rules allow it to be deducted.

If you're married and you file a separate tax return from your spouse, and if you lived apart from your spouse at all times during the year, the maximum rental real estate loss exception for you is $12,500, and the exception begins to phase out at modified Adjusted Gross Income of $50,000 instead of $100,000.

If you're married and file separately but you did not live apart from your spouse at all times during the year, the exception for active rental real estate losses is completely disallowed.

To calculate your deductible loss, you may need to complete Form 8582: Passive Activity Loss Limitations according to the IRS instructions.

If you spend considerable time in real estate activities during the year, you may be eligible for a favorable special rule.

• For so-called real estate professionals (as defined by IRS guidelines), the passive activity rules don't apply to losses from certain rental real estate activities, which means the losses can usually be fully deducted in the year they occur.
• For more information on this beneficial special rule, consult IRS Publication 527: Residential Rental Property (Including Rental of Vacation Homes).

For more on passive activities, see Tax Topic 425: Passive Activities-Losses and Credits.

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