 Income tax 2022-2023, depreciation of rental property makers and special depreciation part number two. Let's do some wealth preservation with some tax preparation. Most of this information comes from publication 527 residential rental property, including rental of vacation homes tax year 2022, you can find on the IRS website irs.gov, irs.gov, looking at the income tax formula we're focused on line one income remember on the first half of the income tax formula is in essence an income statement but just an outline other forms and schedules flowing into these line items one of those the schedule E in essence and income statement in and of itself with rental income minus rental expenses the net rental income flowing into line one income of the form 1040 and our income tax equation we're continuing on with our discussion of depreciation and depreciation is of course a huge topic with rental property because the cost of the rental property is going to be a huge component we would like to be able to deduct the cost when we pay for it up front typically but the tax code doesn't let us do that even if we're using a cash based system they may put it on the books as an asset doing and support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a youtube page we also include added resources such as excel practice problems pdf files and more like quick books backup files when applicable so once again click the link below for a free month membership to our website and all the content on it cruel concept thing and then allocating the cost in accordance with the tax code over the useful life and we're continuing our discussions of that process remembering that the tax code is going to be more restrictive in terms of the categories we've got to put the property into and then and then do the calculations in accordance with the categories we're required to put the property into hopefully with the help of software oftentimes we're now continuing on with the conventions conventions right so conventions we talked about makers as like the primary kind of concept or that we're going to be using in order to depreciate property it's still using general accounting concepts like straight line versus double declining balance type of concepts and then we have a convention involved and that basically is going to say can we simplify things somehow instead of saying i bought something or put it in place on february 21st or something and then having to calculate half you know part of a month a few days of a month we're going to say can we do some kind of convention assuming we purchased it in the middle of the year middle of the quarter or middle of the month as the case may be all right convention is a method established under makers to set the beginning and ending of the recovery period so it's it's designed to be a little bit easier a little bit easier here on the beginning and ending period without those funny fragments of the year so the convention you use determines the number of months for which you can claim depreciation in the year you place the property in service and in the year you dispose of the property obviously the convention is most seen most times when we put the property in service because that's when we have to do the actual calculation of putting it in place and usually the software is going to help us to calculate the depreciation going forward but and so we might not have as much focus is what i'm trying to say at the end of the process of depreciation when the useful life ends but obviously if you put it in the uh in as a half year convention you would think you have to end on a half year note as well would be the general idea so mid month convention a mid month convention is used for all residential rental property and non-residential real property so if you if you're nor if you're used to writing off things like equipment and stuff like that oftentimes they have like a mid month convention we assume i mean i'm sorry mid year convention that that means or or the middle of the year is the going to be the date we put it in service but when you get to something as large as real estate it would make sense that the convention would change from a mid year to a mid month so now we don't have to deal with those weird fractions of a month but we still have that half of a month and part of a year that we have to deal with so under this convention you treat all property placed in service or disposed of during any month as placed in service or disposed of at the mid point of that month the middle point mid quarter convention so in a mid quarter convention must be used if the mid month convention doesn't apply and the total depreciation basis of maker's property placed in service in the last three months of a tax year excluding non-residential real property residential rental property and property placed in service and disposed of in the same year is more than 40 percent of the total basis of all such property you placed in service during the year so in other words the mid month convention you usually think of that as what's going to be used with the big ones the real estate and then we have the mid year convention or half year convention is sometimes called but everything else is mid so it's kind of easy to say mid year half year convention is kind of the default oftentimes when you think of other types of depreciable property like three year and seven year property but then that leads to an incentive for people to try to buy everything like at the end of the year like in December or something and then take a half year convention half year of depreciation when they only when they bought it at the end of the year and therefore the the code says well if you buy a lot of stuff like at the end of the year we're going to make you use a mid quarter convention so that you only get a quarter instead of a whole half of the year if you buy bunch of stuff at the end of the year so under this convention you treat all property placed in service or disposed of during any quarter of a tax year as placed in service or disposed of at the midpoint of the quarter example during the tax year tom purchased the following items to use in his rental property he elects to claim the special depreciation allowance discussed early he elects not to claim the special so notice when we're talking about other property we often we also have these other things that kind of throw wrench into the mix the 179 and the special depreciation stuff that might allow you to depreciate more stuff kind of up front but our focus here is on the makers depreciation remembering that makers is the underlying concept of depreciation it will probably continue forward longer than the special depreciation and the 179s which are kind of deviations political kind of things to manipulate the market and or economy all right so a dishwasher four hundred dollars that he placed in service in january then he had used furniture for one hundred dollars that he placed in service in september a refrigerator for eight hundred dollars that he placed in service in october so tom uses the calendar year as his tax year the total basis of all property placed in service that year is one thousand three hundred dollars so the eight hundred dollar basis of the refrigerator placed in service during the last three months last three months last quarter of his tax year exceeds uh exceeds five hundred twenty forty percent of one thousand three hundred so he's over that threshold so therefore tom must use the midquarter convention instead of a half-year convention for all three items which is a less advantageous convention generally because you have to only get a quarter possibly of the depreciation as opposed to half of a year three months instead of six months so half-year convention the half-year convention is used if neither the midquarter convention nor the mid-month convention applies in other words the cat the half it's kind of backwards the way they put it in place here because you know obviously the half-month convention would kind of be the default generally unless there was there was purchases that happened at the end of the at the end of the quarter that took you from the half-year convention and forced you to use the mid-month convention you had to do the test to see whether you had to do the the mid-quarter convention from the half-year default and then the real estate is on the mid-month convention because it's the big stuff okay so here we go so under this convention notice it says half-year instead of mid-year so you probably hear a lot of people including me call it mid-year sometimes because everything else is mid mid mid and then we got a half-year so under this convention you treat all property placed in service or disposed of during a tax year as placed in service or disposed of at the midpoint of that tax year if this convention applies you deduct a half-year of the depreciation for the first year and the last year that you depreciate the property you deduct a full year of depreciation for any other year during the recovery period figuring your depreciation deduction you can figure your maker's depreciation deduction in one of two ways the depreciation is substantially the same both ways you can figure the deduction using either the depreciation method and convention that apply over the recovery period of the property or the percentage from the maker's percentage tables so in other words you can basically kind of calculate the depreciation so if it's a double declining basis you can kind of calculate the depreciation but the double declining in particular gets confusing especially when you throw in the half-year convention and whatnot so you could see you could use the percentage tables which basically are you know they've short-cutted some of the calculations obviously in practice we'll probably use software to calculate it but we still want to have an idea of what's going to happen into the future and if we can calculate out into the future these these costs that also helps us to do projections because tax software often helps us for the current year and possibly into the next year but if it's a 30-year property or something we might want to or any year property five-year property what we might want to project out further to make our decisions so in this publication we will use the percentage tables for instructions on how to compute the depreciation you could see chapter 4 publication 946 if you so choose residential rental property you must use the straight line method and a mid-month convention for residential rental property so the big stuff the actual property itself straight line which is the most basic convention the first thing we would think of when we think of this concept of depreciating but it's the worst one for in terms in comparison to to an accelerated method like double declining because we would rather get depreciation sooner rather than later which makes sense from the irs perspective for real estate because although real estate the building deteriorates over time it's possible the real estate of course goes up in value just due to the location which is different than other pieces of equipment and stuff like that so it kind of makes sense that we wouldn't accelerate the depreciation but rather kind of depreciate it evenly over the the useful life which would be fairly long you would think right so in the first year that you claim depreciation the residential rental property you can claim depreciation only for the number of months the property is in use so i used a mid-month convention explained under conventions earlier so then you got the five seven fifteen year property for property in the five seven uh or seven year class used the 200 percent declining balance so that's the one we get the better benefit method the double declining balance the accelerated method up front more complex to calculate but uh it's better for taxes because usually we get the benefit sooner which is usually uh better it's also by the way conceptually sound oftentimes from an accounting standpoint because if you buy something like a forklift you might say hey straight line isn't as accurate as double declining just to be fair because the forklift is going to be more productive in the first first year than the late latter years therefore i should allocate more of the cost in the beginning years when i get more of the benefit and then into the latter year so it's still a conceptually sound it's not just a crazy wacky political you know thing uh so any case so that's the double declining method and a half year convention so however in limited cases you must use the mid quarter convention if it applies we talked about the whole convention thing half year is the is the standard unless something funny happens you bought a bunch of stuff at the end of the year in which case you flop on over to mid half uh mid quarter so the property in 15 year class uses the 150 double declining method so that's accelerated but not as accelerated as 200 method and a half year convention unless the mid year convention applies so you can also choose to use the 150 percent double declining method for property in the five or seven year classes so in other words they're giving you a little bit of leeway and the five or seven you could say i got 200 percent double declining i could default down to 150 but normally you wouldn't want to do that because we'd rather have the depreciation sooner rather than later unless we have we're expecting to have more income in the future than currently and therefore we're going to be in higher tax brackets in the future in which case maybe it would be advantageous to delay the depreciation so that we can take it when we have higher income or something possibly so the choice to use the 150 method for for one item in a class of property applies to all property in that class so then you have to kind of think about it as the whole class total if you're flopping it over from 150 to 200 to 150 placed in service during the tax year you make this election on form four five six two part three column f enter 150 double db once you make this election you can't change it you can't be flip flopping after you've started a depreciation method got to be consistent so if you use either the 200 percent or 100 percent db double declining balance a method figure your deduction using the straight line method and the first tax year that the use of the straight line method gives you an equal or larger deduction than the use of the 200 or 150 db method so it gets a little bit funny when you when you think about the calculations from straight line to double declining because what happens is like like if you had a well we'll probably if you had a straight line method that was for an entire year then it would come out to the same number as a double declining balance with a half year convention so that kind of confuses people because that first year looks like a straight line method in any case you can you can also choose to use the straight line method with a half year or mid quarter convention for five seven or 15 year property so now we have the option 200 percent that's probably the best most of the time but sometimes maybe we want to default down to the 150 if we think we're going to make more money in future periods or something or possibly all the way down the straight line which means it's going to take us longer or we're going to get more depreciation at the end or you know then we would under the double declining so the choice to use the straight line method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the depreciation you elect the straight line method on form four five six two part three column f enter s dash l all right makers percentage what percentage is that Kevin tables you can use this percentage tables and table two two to compare annual depreciation under makers the table show the percentages for the first few years or until the change to the straight line method is made so when you do a double declining method you basically calculate the double declining it doesn't work perfectly the calculation until the straight line is higher than the double declining method would be and then you switch over to straight line and then you kind of fudge the last year to make it to make it work because it's kind of a it's kind of a not the most precise elegant calculation of a method but it works it works so see appendix a of publication 946 for complete tables so the percentages in table two dash two a two dash two b and two dash two c make the change from using the db method to the straight line method in the first tax year that the use of the straight line method gives you an equal or greater deduction than the use of the db method so if you elect to use the straight line method for a five seven or fifteen year property or the 150 db method for five or seven year property use the tables in appendix a of publication 946 again usually software will help us but the tables could help us to easily calculate projections out into the future past maybe what the software might do in some cases so how to use the percentage tables you must apply the table rates to your properties uh unadjusted bases define later each year of the recovery period so once you begin using a percentage table you figure depreciation you must continue to use it for the entire recovery period unless there is an adjustment to the basis of your property for a reason other than uh two depreciation allowed or allowable or an addition or improvement uh that is depreciable as a separate item of property okay if there is an adjust an adjustment for any reason other than one or two for example because of a deductible casualty loss you can you can no longer use the table for the year of the adjustment and for the remaining recovery period figure depreciation using the property's adjusted basis at the end of the year and the appropriate depreciation method as explained earlier under figuring your depreciation deduction all right uh unadjusted basis this is the same basis you would use to figure gain on a sale see basis of depreciable property earlier but without reducing your original basis by makers depreciation taking in earlier years so in other words when we start to think about calculating the depreciation we're going to say we have the concept of basis which is kind of like the cost oftentimes uh plus any other things we needed to put in place and then we're going to calculate the depreciation which the straight line method would be saying i'm going to take the the basis divided by the number of years and allocate it evil evenly but an accelerated method is going to be using a percent to multiply by now we can if we were calculated ourselves we would have to keep on calculating the adjusted basis to then figure out and then multiply it times the times the double declining rate but the tables kind of eliminate that and they're going to do the calculation on the original basis that's why it's a more simplified calculation makes it easier to do although conceptually it's hard to understand what it is doing so however you do reduce your original basis by other amounts claimed on the property including any amortization any section 179 deduction any special depreciation allowance for more information you can see chapter four publication 946 tables 2-2a uh 2-2b 2-2c the percentage in these tables take into account the half year and mid quarter conventions so when you think about the calculation of depreciation it's fairly straightforward and then it gets more complicated when you throw in the fact that you have this partial year in the first and last years and and that's where the conventions come in so now you have to use a different table depending on whether you're going to be taking into account half year mid quarter mid month convention so use tables 2-2a for five year property table 2-2b for seven year property table 2-2c for 15 year property use the percentage in the second column half your convention unless you are required to use the mid quarter convention explained earlier if you must use the mid quarter convention use the column that corresponds to the calendar year quarter in which you place the property in service so here we have table 2-2 we've got the years we've got the half half year conventions and then here we have the if we have the mid quarter convention then it gets more complicated because there's four quarters right so now we got the first second third quarter fourth quarters and we've got to use the percentage that are applicable for the mid quarter the seven year property half year conventions and then the mid quarter once we choose the right table then it becomes a lot easier because then all we have to do is take our original cost or basis and multiply it times these percentages as opposed to if we were using a double declining balance method having to then figure out the new adjusted basis and multiply that times the double declining rate and figuring out if that's greater than the straight line and so on and so forth so these again are quite useful if you're projecting out into the future obviously in practice software helps us to do the calculations as well 15 year property same thing half your convention mid quarter residential real real property gets more cumbersome because now you've got now you've got the percents that are mid month conventions so you could have bought it in the middle of january february march or whatever so now you've got to have 12 separate set of tables depending on because you could have bought it at any month in the year okay so example you purchased a stove and refrigerator refrigerator and placed them in service in june so your business uh your basis in the stove is six hundred dollars and your basis in the refrigerator is one thousand dollars both are five year property using the half your convention column table the depreciation percent for year one is 20 percent for that year your depreciation deduction is 120 for the stove and 200 for the refrigerator so that's multiplying it by the amount on the table now notice if you if you said okay well it's a double declining balance how would i do it if i didn't use the tables it would be something like well it would be six hundred dollars and then i'd have to divide it by the number of years it's going to be depreciated over five not 56 five 120 i can come up with the straight line rate then which would be 120 divided by 600 or 20 percent 20 percent would be uh the rate i can also get there by saying one divided by the number of years five 20 percent if i multiply that times two the double declining rate is actually 40 percent so if i was to do this without the tables i would have to take the double declining rate times the 600 which is 240 and you're like well wait that's too high but that's because that's for an entire year and then i would divide that by two for the half year convention to get back to the 120 now that 120 looks like the straight line number but this it would be the straight line number for an entire year and we're only getting six months so the double declining in the first year uh results half year convention results in the same number we would have got in the first year had it been the whole year for straight line method however the second year will be different because in the second year i'm going to have to if i was to calculate it using my the arm method we'd have to take 600 minus what we depreciate a last time 120 and then multiply it times the double declining rate right whereas if i use the tables i can just multiply it times the table i don't end times the 600 i don't need to keep figuring out the the basis the adjusted basis okay so for year two the depreciation percent is 32 percent so so that year's depreciation deduction would be 192 see that's the same number i calculated here but they did it by just multiplying 600 times 32 which is a lot easier okay so for the stove and 320 for the refrigerator okay example two assume the same facts as an example one except you buy the refrigerator in october instead of june because the refrigerator was placed in service in the last three months of the tax year and its basis 1000 is more than 40 percent of the total basis of all property placed in service during the year now you got to use the mid quarter convention so now now you've got 1600 times 40 percent uh you are required to use the mid quarter convention to figure depreciation on both the stove and the refrigerator because you place the refrigerator in service in october you use the fourth quarter column of table two dash two a and find the depreciation percent for year one is five percent your depreciation deduction for the refrigerator is 50 okay because you place the stove and service in june you use the second quarter column of table two dash two a and find the depreciation percent for year one is 25 percent for that year your depreciation deduction for the stove is 150 okay table two dash two d use this table when you are using the gds uh 27.5 so now we're talking for the real estate your option for residential rental property find the row for the month that you place the property in service so now there's 12 different months now this one would be easier in some ways to calculate just normally because it's straight line it's not double declining but you still have that mid month convention which kind of makes it a little confusing for the first month at least so use the percentages listed for that month to figure your depreciation deduction the mid month convention is taken into account in the percentages shown in the table continue to use the same row month under the column for the appropriate year example you purchased a single family rental house for $185,000 and placed it in service on February 8th the sales contract showed that the building cost 160,000 and the land cost 25,000 remember that's an important distinction meaning you bought the whole thing for 185 we've got a breakout between land and building possibly using property tax schedules or something the property tax bill which has an assessment related to it to help us to figure that out because the building is the depreciable part the land is not so your basis for depreciation is its original cost 160,000 this is the first year service for the residential rental property and you decide to use gds which has a recovery period of 27.5 years which most people would because it's it's less than our other option in terms of the number of years allowing us to get the expense sooner using table 2-2d you find that the depreciation percent for property placed in service in february of year one is 3.182 percent that year's depreciation deduction is 5,091 160,000 times that percentage okay figuring makers depreciation under ads table 2-1 shows the ads recovery periods for property used in rental activities see appendix b of publication 946 for other property if your property isn't listed in appendix b it is considered to have a no-class life under ads personal property with with no-class life is depreciated using a recovery period of 12 years use the mid-month convention for residential rental property and non-residential real property for all other property use the half-year and mid quarter convention as appropriate